There are also indirect linkages between macro and financial stability through the main instruments used to achieve them. The main tool used by most central banks to achieve macro stability is the management of a short term reference interest rate. Movements of this benchmark rate not only directly affect the consumption/saving decisions of firms and households, but also have consequences for all asset prices (e.g. equities, bonds, exchange rates, housing), the cost and availability of credit, and the willingness of investors to take risks. For instance, in a stable context, persistently low interest rates may generate incentives for investors whose income depends on absolute returns (such as hedge fund managers and insurance companies) to invest in more risky assets. It may also make it more profitable to engage in carry trades and create currency or maturity mismatches. On the unintended side, the success in achieving macro stability may change the perception of agents about the riskiness of the environment and lead them to take more risky bets in the expectation that good times will continue indefinitely (or at least until the bet pays off). Also, the way to deal with bubbles in monetary policy in the US, applying the so-called Greenspanput (Blinder and Reis, 2005), may have increased the chance of bubble formation (De Gregorio, 2011).
Of course, this policy is not free of cost, since holding reserves is costly, and therefore its use is limited.4 It is difficult to recommend a particular strategy, since realities are different across countries, not only on the nature and impact of capital flows, but also on the overall macroeconomic policy framework and deepness and strengths of financial systems. However, the general principles discussed above should be taken into consideration. Final remarks The connections between price and financial stability suggest that the central banks should consider the cross effects of financial policies and monetary policy. In countries like Chile, the central bank has an explicit mandate on financial stability, and many other countries are moving in this direction as the interactions among policies have been recognized. But also, it is important to have a close and continuous coordination among all authorities with responsibilities on the financial system. This coordination becomes also more needed in times of crisis or extreme distress, since the central bank has to implement its LLR functions. In normal times, the pursuit of price stability in a small open economy is not in contradiction with financial stability in the presence of capital flows. In this context, the potential vulnerabilities to high exchange rate volatility can be handled with prudential regulation. However, in episodes of capital surges that may affect macroeconomic and financial stability a close coordination of monetary policy and prudential policies is required. References Bernanke, B.S.