In particular, they would be able to respond appropriately to changes in interest rates and other variables in the rest of the world. If countries nevertheless choose a peg to the dollar, with capital inflows, bubbles, and other negative effects, they are themselves responsible for those effects. Consider the following thought experiment.6 Let the world consist of two large economies, called the domestic and foreign economy, respectively. Let the domestic economy be an emerging-market economy with flexible inflation targeting, a flexible exchange rate, and free capital flows. Suppose that the domestic economy is initially in an equilibrium with the inflation forecast on the inflation target, the resource-utilisation forecast at a sustainable level, a constant exchange-rate forecast, zero capital flows, and a given policy-rate path consistent with this. Suppose the foreign interest rate falls, due to more expansionary monetary policy in the foreign economy in order to increase demand and activity in the  5  Eichengreen, Rajan, and Prasad are members of the Committee on International Economic Policy and Reform, a non-partisan independent group of experts (academics and former government and central bank officials). In its September 2011 report (Eichengreen et al. 2011), the committee suggests that “[m]echanisms should (…) be developed to encourage large-country central banks to internalize the spillover effects of their policies.
Of relevance is that excessive risk-taking behaviours featured prominently as a key factor contributing to the Crisis. In addition, what makes the Global Financial Crisis different is the extent of the economic and financial inter-linkages within and across borders, which explains the far-reaching impact of the crisis. While the greater interconnectedness of economies and financial systems has brought about opportunities, it has also resulted in greater risks. The Global Financial Crisis has resulted in the re-assessment of how policymakers view the achievement of macroeconomic and financial stability. There is a growing recognition that emerging risks to macroeconomic and financial stability have to be identified and managed in a more holistic and effective manner. As the economy and financial system grow in complexity, policymakers have to strengthen the understanding of the macroeconomic and financial inter-linkages in order to be able to effectively assess the implications of any potential risk on the economy. Before the Global Financial Crisis, the predominant view was that unfettered markets, selfcorrections and minimal interventions would deliver the best economic outcomes. However, recent experiences have shown that policy interventions to correct market misalignments after a crisis may prove too late as the aftermath could be extremely costly. This, therefore, call for policies to be pre-emptive rather than reactive. For policymakers, the aim is to preserve macroeconomic and financial stability, and build the country’s resilience to shocks. Macroeconomics stability is a very important prerequisite for businesses and individuals to undertake economic activities.