Something that no doubt helped to question the explanatory power of the efficient-market hypothesis was the stock market crash in 1987, when the Dow Jones index plummeted 22.6 per cent - the largest-ever one-day fall in the United States. This dramatic event demonstrated that share prices can fall even though nothing more fundamental appears to have happened; a thorough search failed to detect any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one-day share 2 price movements in the United States in the post-war period confirms this. Moreover, a number of studies have shown that price movements have occurred solely because the company in question has been included in or excluded from Standard & Poor’s 500 index, without any new information about fundamentals. Various explanations for such overreactions have been found. For instance, research has shown that risk management systems and the use of strategies such as stop-loss limits and VaR limits, theoretically could cause financial markets to overreact. Other research has shown that different forms of psychological factors can also cause those developments. Experimental psychology has found that people often perceive a wider pattern in the light of just a few observations that are actually entirely random.
As such, “Policy dilemma” in Emerging Market Economies is likely to become more pronounced, especially as policy rate hikes from external front are imminent. Along the way, clear and timely policy communications from Advanced Economies will be useful to prepare for any adverse side-effects going forward. Part III: Key policy takeaway and the importance of policy collaborations Ladies and Gentlemen, In preparation for upcoming challenges, policymakers wish to do better than passively “catching up” with the crisis, but to be actively “ahead of the crisis” in order to prevent, or at least, mitigate the impact should one occur. Against this backdrop, lines of policy defenses for each economy have to be strengthened. 2  BIS central bankers’ speeches  If we think of the economy as our own house, then keeping the house in order is always an effective first line of defense. Strong economic fundamentals and macroeconomic policy credibility would play a crucial role in ensuring confidence and the sustainable economic activities. Nonetheless, increasing interconnectedness has made housekeeping more difficult as it creates spillovers. To better deal with the shocks, broader set of policy tools are called for. In a nutshell, sound macroeconomic policy and flexible macro-prudential measures to target vulnerabilities have been employed to minimize unprecedented impact in an appropriate and timely manner. Nonetheless, these policies are reaching their limits, not only in terms of policy space but also effectiveness. For a better solution, reforms in both the financial and real sectors are essential.