Bean, Charles R. (2009), “The Great Moderation, the Great Panic and the Great Contraction”, Schumpeter Lecture, Annual Congress of the European Economic Association, www.bankofengland.co.uk. Borio, Claudio and White, William R. (2003), “Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes”, in Monetary Policy and Uncertainty: Adapting to a Changing Economy, Federal Reserve Bank of Kansas City Jackson Hole Symposium, 131212. 11  Walsh (2009) points out that when financial factors cause distortions, these distortions will in general introduce corresponding terms in a loss function for monetary policy that is a second-order approximation to household welfare. Curdia and Woodford (2009) present a model where the second-order welfare approximation is a standard quadratic loss function of inflation and the output gap between output and potential output, but where potential output is affected by financial factors. Then inflation and the output gap remain the target variables, with and without financial factors. The neutral rate in the model, that is, the real rate consistent with output equal to potential output, is then also affected by financial factors. 12  See Svensson (2003b) for further discussion of the important distinction between the response variables in the policy reaction function (the variables that the central bank responds to) and the target variables in the loss function (the variables that the central bank “targets” and wants to stabilize at their target levels).
Maintaining financial stability, including a well-functioning payment system, is, explicitly or implicitly, an important objective for central banks. In my overview of best-practice monetary policy in Svensson (2002), long before the crisis but during an ongoing debate about monetary policy and asset prices, I briefly discussed how this objective can be reconciled with flexible inflation targeting, how conflicts can arise and how they could be handled. 4 One question is whether financial stability belongs in the loss function for the central bank, together with inflation and resource utilization. I argued that a good way of handling this additional objective is as a constraint on monetary policy rather than as a separate target variable that appears in the loss function. The idea is that financial stability is normally pursued with different instruments, such as supervision and regulation, and is normally not a concern for monetary policy. Under normal circumstances, at least in industrialized countries, financial stability is good and does not impose any constraints on monetary policy. Only rarely, when financial crises occur, does financial stability impose constraints on monetary policy and force the central bank to modify its decisions.