Although there is a, by now extensive, literature on financial frictions, including attempts to incorporate them in New Keynesian models, it turns out that such extensions make little difference to the propagation of shocks, to optimal policy, or to the quantitative conclusion that overwhelmingly the most important objective remains inflation stabilisation. 12 There is no doubt that financial frictions such as asymmetric information, credit constraints, and costly monitoring of borrowers, to name but a few, are an important part of the story of how crises happen and why they impact on output. But those models do not provide a convincing account of the gradual build-up of debt, leverage and fragility that characterises the run-up to financial crises. 13  8  This specification of the objective function can be derived as an approximation to the maximisation of the welfare, defined over consumption and leisure, of a representative consumer with an infinite horizon (see Rotemberg and Woodford, 1997). 9  The frontier is named after the US economist John Taylor. 10  To implement such a policy reaction function requires an empirical judgement about the factors that drive the volatility of both inflation and output. In principle, these should include those factors in the banking and financial system, including movements in asset prices, that generate fluctuations in demand and output and affect the way in which shocks are transmitted through the economy. In practice, however, rather little attention was paid to the role of the banking system in determining inflation and output. 11  Brazier et al.
Their conversations during the 1930s, at the height of the Great Depression, are eerily reminiscent of the enormous challenges we face today, as you can see from the following exchange in 1930: KEYNES: Is not the mere existence of general unemployment for any length of time an absurdity, a confession of failure, and a hopeless and inexcusable breakdown of the economic machine? STAMP: Your language is rather violent. You would not expect to put an earthquake tidy in a few minutes, would you? I object to the view that it is a confession of failure if you cannot put a complicated machine right all at once. KEYNES: In my opinion the return to the gold standard in the way we did it set our currency system an almost impossible task ... If prices outside this country had been going up since 1925 that would have done something to balance the effect on this country of the return to the gold standard. STAMP: Hush, Maynard; I cannot bear it. Remember, I am a Director of the Bank of England. In some respects our experience today is no different: putting right our economic machine is proving a slow and difficult task. But in the 1920s the Government made the task substantially harder by reinstating the gold standard at a rate that left sterling overvalued. Today, monetary policy is part of the solution, not part of the problem. That is thanks, in large part, to the monetary framework we have had in place since 1992.