First, in a financially integrated world it has been argued that it is global monetary liquidity rather than domestic liquidity which affects domestic interest rates and domestic economic activity, mainly – though not exclusively – through its effects on liquidity premia. Second, it has been claimed that the level of longer-term domestic real interest rates is likely to be determined by global savings and investment rather than its national components. These influences can be expected to be more pronounced for smaller economies. Therefore, a smaller country which cannot affect the global supply of liquidity to any significant degree could then lose effective control of inflation. This reasoning, however, is dubious, and not supported by theory or confirmed by empirical evidence. For example, in a two-country new Keynesian model, it has been shown that, provided exchange rates are flexible, global monetary factors can affect the domestic price level only through their potential short-term effects on global output. 1 Interestingly, the sign of the spill-over effect is the opposite of what would be expected from the global liquidity hypothesis. A comparatively loose foreign monetary policy induces a depreciation of the foreign currency and has a negative impact on domestic demand and prices in the home country. The main conclusion of rigorous theoretical analysis is that monetary policy can affect domestic demand even in a fully financially integrated world and even in a small country, as long as exchange rates are flexible.
Causes of the financial market turmoil What have been the underlying main causes of the financial market turmoil? What have been the key weaknesses in the functioning of the financial system that have been revealed? And what are the appropriate further responses of market participants and policy-makers? A full diagnosis of the causes and weaknesses is not yet complete and, indeed, not possible as the  19  8  See ECB (2007b), Box 7, on the propagation of the sub-prime shock to other markets. BIS Review 9/2008  market adjustment is still ongoing. Nevertheless, I would like to highlight four areas that are also pertinent to the issues of financial integration and development we are discussing. •  First, the underlying causes and triggers are to be found in the price dynamics of the US housing market and the excesses and shortcomings (in the practices) in the US sub-prime mortgage market. So, a main determining factor of the financial market turbulence is that same one – property price overvaluation – that characterised previous episodes, as emphasised by Kenneth Rogoff. •  Second, weaknesses in the functioning of the market for structured finance products. These included valuation uncertainties due to the complexity of many products, the imperfect information available about the underlying asset characteristics, inadequate appreciation by investors of the embedded risks, and excessive reliance on the ratings of such products by credit rating agencies.