It is worth noting that the transmission mechanisms under study do not stem from the traditional recommendation of Friedman (1959) in his famous A Program for Monetary Stability, where the focus is on money demand stability and the role of money as a price anchor, and whose analytical base is the quantitative theory of money. Actually, recent works that assign a role to money, and to credit in general, do so because it can reveal future inflationary pressures or because it can contribute to achieve increased stability (Christiano et al., 2007; Goodfriend and McCallum, 2007; Kilponen and Leitemo, 2008). Nonetheless, the empirical evidence on the ability of money to provide information to forecast inflation is not so favorable to monetary aggregates. 5 It is more promising to conceive monetary and credit aggregates as indicators of potential distortions in financial markets, an issue I will discuss in the next section. In this review of inflation targeting regimes it is worth to bear in mind that they are subjected to stress when inflation is of external origin and corresponds to a cost (or supply) shock. A cost shock that increases inflation may require a restrictive monetary policy in order to prevent relative price increases from snowballing into an inflationary spiral. In any case, and to avoid costly repercussions in terms of output losses, a horizon is established to correct deviations, which permits relative price changes to occur without requiring sharp monetary policy adjustments .
It is necessary to continue strengthening the robustness of these methods to evaluate situations of extreme tension. Starting tomorrow, the Central Bank of Chile will hold its Annual Conference, and this version will feature frontier work in this area. From the regulatory standpoint, supervision must consider the macroeconomic impact of financial activity. In the months to come, we will have to analyze also the potential procyclicality of the Basel II capital requirements, as well as the modeling and quantification of liquidity risk. A regulatory framework will be necessary to ensure the building of sufficient reserves in the boom phase of the cycle in order for the financial system to be well capitalized when the bust phase comes. 9 One of the most recurring sources of financial stress in the past few years in emerging economies are periods of euphoria or pessimism, which trigger movements in their exchange rates beyond what their fundamentals would justify. For example, when economic expectations are good, foreign exchange appreciations can arise with symptoms of bubbles in favor of all the domestic assets. As I discussed before, a first line of defense for specific asset prices, stocks or housing is to raise the interest rate. However, in the area of exchange rates this may trigger more pressures to appreciate and exacerbate financial imbalances.