In the modern literature, these risk premia are taken to be determined by how useful a financial asset is in helping households to smooth the path of their consumption. Assets that deliver low returns during bad times don’t contribute much to helping households sustain consumption, and so carry a higher risk premium. So risk premia might vary with the volatility of the asset return; the volatility of consumption; and with the correlation between asset returns and consumption. 16  See Dooley, M.P, Folkerts-Landau, D and Garber, P (2003), “An essay on the revised Bretton Woods System”, NBER Working Paper 9971. “System” is not quite the right word, because it is not the product of collective international thought and planning. 17  See Tucker, PMWT (2006) “Uncertainty, the implementation of monetary policy and the management of risk”, Bank of England Quarterly Bulletin 2006 Q2 pp 202-211. BIS Review 112/2008  9  Like other economic variables, such premia may change as their underlying determinants change, and given the nature of the “shocks” affecting the macroeconomy. All that is familiar, fairly orthodox stuff these days. Indeed, an extraordinary amount of work at the macro/financial frontier has been going on over recent years. But as John Cochrane has commented, “work has barely begun”. 18 From a policymakers’ perspective, that does seem to be the case.
For a given path of nominal demand, that would tend to reduce the pressure of demand on global commodity prices, as many of the largest EME economies are, basically, commodity importers themselves. But persistent elevated inflation in the EMEs would also increase the nominal price of some of our imports, unless an adjustment in nominal exchange rates were permitted. In fact, over recent months there have been some steps towards taking domestic monetary action across a number of emerging market economies. But there is a risk that higher EME inflation will persist if, left unchecked, it becomes embedded in inflation expectations. With inflation also elevated across the major industrialised economies, this underlines the risk to global inflation from imbalances in global supply and demand. Individual countries can suffer exogenous shocks to inflation from commodity prices, but that is essentially a relative price shift, to which the world economy has to adjust. By contrast, a persistent rise in inflationary pressures cannot be exogenous for all countries collectively. In that respect, the international monetary regime, and the global imbalances it has sustained, continues to pose risks to the outlook for our economy. Indeed, in terms of where we find ourselves, we must take care not to put the cost shock and the credit shock in completely separate boxes. They both owe something to global imbalances.