In a second-best situation, without appropriate supervision and regulation, if the policy rate is the only available tool and there is a trade-off between its effect on the monetary-policy objectives and financial stability, that trade-off should be taken into account. Normally, however, the policy rate is not the only available tool, and much better instruments are available for affecting financial stability. Monetary policy should be the last line of defence of financial stability, not the first line.4 In discussions of monetary policy and financial stability, there have been many references to the “risk-taking channel” (Borio and Zhu 2008), according to which leverage and risk in the financial sector increase with lower policy rates. However, the general discussion on and the existing models for policy rates, the risk-taking channel, and so on consistently seem to suffer from confusion between nominal policy rates and the general level of real interest rates. Models such as those of Adrian and Shin (2011) and Diamond and Rajan (2011) include a short real rate but no nominal policy rate and no explicit monetary policy. Furthermore, there is no distinction between the short real rate and the neutral real rate. What monetary policy in the real world can do by setting a short nominal policy rate is only to temporarily make the short real interest rate deviate from the neutral real interest rate, which in turn is beyond the control of monetary policy.
I do not agree with that conclusion. It seems to me that the problems for the emerging-markets concerned to a large extent depend on the decision of these countries to stabilise their dollar exchange rate or even peg to the dollar. Countries that choose to peg to the dollar will tend to import U.S. expansionary monetary policy into to their own country. This monetary policy may in many cases be too expansionary for the countries concerned, creating an overheated economy with risks for bubbles and other negative consequences. A flexible exchange rate would give the countries the option of conducting an independent monetary policy appropriate for the country in question. If countries nevertheless choose a peg to the dollar, with capital inflows, bubbles, and other negative effects, they are themselves responsible for those effects. More expansionary monetary policy, for instance, in the U.S. in the form of lower long rates due to LSAPs, tends to depreciate the dollar, all else equal. This does not mean that the U.S. is conducting a beggar-thy-neighbour policy that hurts other countries. A weaker currency is a normal consequence of more expansionary monetary policy in an open economy. Other countries can adjust their policy in response. All countries cannot depreciate their currency against each other, but all countries can conduct more expansionary policy if they prefer, using conventional or unconventional policy tools. This will increase real activity and both exports and imports, which in a situation with underutilised world resources is to the benefit of all.