Because this would call for greater variation in employment and growth, an outside observer would, all else equal, infer a lower value for lambda. This is when different views regarding the transmission mechanism of monetary policy become relevant. Those who regard the impact of monetary policy on the economy as relatively rapid may be more inclined to 22  See e.g. Blanchard, O, Cerutti, E and Summers, L (2015), “Inflation and activity – two explorations and their monetary policy implications”, NBER working paper No. 21726. 23 At root this is because, in aggregate, retailers whose costs rise adjust their prices only gradually, perhaps reflecting strategic, competitive concerns, or because many importers, over the short term at least, hedge their foreign exchange exposure. See Box on page 28 of the November 2015 Inflation Report for a review. 12  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches  12  act in response to shocks whose effects are relatively short-lived. All else equal this would tend to produce a shallower observed relationship between inflationary shocks and output gaps – a lower lambda. If, on the other hand, monetary policy is viewed as operating with a substantial lag, it may be that the more enduring influences on inflation are the ones that weigh most heavily in the monetary policy decision. In this case, this would tend to produce a steeper observed relationship between inflationary shocks and output gaps – a higher lambda.
This “procyclicality” mechanism works to exacerbate real shocks, raise the degree of economic fluctuations, and in extreme cases can play a part in leading to financial or economic crises. One remedy to this problem is to utilize the supervisory and regulatory function in pursuit of macroeconomic and system-wide stability objectives, particularly by reducing the degree of procyclicality. Such “macroprudential” approach to regulation is rapidly becoming a received wisdom among academics and practitioners, and indeed is the guiding principle underlying the recently finalized Basel III proposal. While it is encouraging that practical implementation has already been set in motion, there remains a degree of opaqueness at the conceptual  BIS Review 143/2010  1  level about the desirable features that should govern the design of macroprudential policy. This point leads me to my second topic that I want to focus my talk on today, that is macroprudential policy and long-term financial stability. In my view, there are three important issues regarding macroprudential regulation. The first is the objective of macroprudential policy, which conceptually is to safeguard financial stability. But, for practical purposes, the notion of financial stability is much more obscure compared to price stability, and the question of how macroprudential policy should be designed to target something that is loose in concept and difficult to measure in practice remains a challenge.