The bottom line is that we may yet encounter a few potholes on the way to the exit. But the good thing is that banks are better capitalised now than in the run-in to the crisis, leverage is lower, there is better visibility of counterparty exposures, and we are better placed to deal with financial institutions that get into trouble. So the risk of major financial problems crystallising in the advanced economies should be much lower. Those emerging economies that have financed large external deficits through the accumulation of foreign currency debt may be more vulnerable, however. Let me turn now to the impact of the crisis on the monetary policy framework itself. Before the crisis, the conventional wisdom in central banks was that monetary and financial stability were largely complementary in nature. The maintenance of price stability would help foster stable macroeconomic conditions more generally by anchoring expectations. And the consequent reduction in macroeconomic volatility should help reduce the likelihood of episodes of financial instability. All that was necessary was for banking supervisors to ensure that individual financial institutions followed responsible lending policies and all would be well. Today, there is a tendency to claim that the crisis revealed a fatal flaw in focussing on price stability as the primary object of monetary policy, namely a failure to recognise that it could in some circumstances actually be detrimental to financial stability.
IS is an aggregate demand schedule, with demand a decreasing function of both the policy rate, R, and a macroprudential instrument, K. PC is an expectations-augmented Phillips curve, in which inflation expectations are assumed to be anchored at the inflation target. 6 For any given set of shocks to aggregate demand and supply, the inflation target can be achieved by the set of pairs of R and K along the downward sloping schedule PS (for Price Stability) in the righthand diagram. An increase in demand resulting from, say, an increase in the propensity to invest, would shift this schedule out to the right. 6  6  In the literature, credit frictions and macroprudential policies can also affect potential output; see for instance Vasco Cúrdia and Michael Woodford (2010), “Credit spreads and monetary policy.” Journal of Money, Credit and Banking 42(S1), pp3–35. For simplicity of exposition, I abstract from such effects here. BIS central bankers’ speeches  Turn now to the credit market. Conventional macroeconomic analyses of the market for loanable funds tend to focus on the flow of funds from saving households to businesses undertaking capital expenditures. But, as Chart 9 makes clear, such lending constitutes only a small fraction of the assets held by UK banks. The vast majority of loans are instead provided to finance the acquisition of existing assets, especially real estate. This should be borne in mind when contemplating the factors behind the demand and supply of credit, shown in the left-hand panel of Chart 10 as CD and CS respectively.