In the absence of other instruments, the case for “leaning against the wind” by setting policy rates higher during the boom phase seems stronger than before. But, at least most of the time, monetary policy does not seem like the most appropriate instrument to call on – it is not targeted at the key friction and involves too much collateral damage to activity. The deployment of macro-prudential instruments, focussed more directly on the source of the excessive exuberance seems more appropriate. But we still have much to learn about how such instruments work in practice and how they interface with monetary policy. 7. The relationship between price stability and financial stability. It is now pretty clear that price stability is not a sufficient condition for financial stability. Indeed, the empirical results of Section 2 suggest that the reduction in volatility associated with the Great Moderation may have contributed to excessively optimistic assessments of risk, the compression of risk premia and the expansion in leverage. That does not imply central banks should retreat from the pursuit of price stability, and macroeconomic stability more generally. But it does suggest that policy makers need both to be aware that long periods of benign conditions may foster excessive private-sector risk-taking, and to be ready to take the necessary action when that happens. 24  BIS Review 111/2010  Appendix: The model of Section 5 The model is a slimmed down version of Gertler and Karadi (2009). The economy is populated by two types of agents: producer/consumer households and bankers.

BIS Review 82/2007  5  More generally speaking, evidence indicates that the reallocation of capital from declining industries to industries with high investment opportunities and high productivity is faster in countries with developed financial markets 12 . These findings suggest that countries with more liquid capital markets and a developed banking system are growing faster on average 13 . Supporting an innovative environment Finally, to fully exploit productivity potential, the labour and product market reforms I just mentioned need to be accompanied by policies that support innovation and technological changes. These include, inter alia, the unlocking of business potential by creating an entrepreneurial-friendly economic environment, measures to support innovation through higher investment in research and development (R&D) and policies aimed at improving human capital. The performance of the Finnish economy illustrates all the benefits arising from developing a “knowledge based-economy” as targeted by the Lisbon agenda. Finland has been ranked by the World Bank among the top world and European countries regarding the ease of doing business. Moreover, Finland is ahead of most European countries when looking at venture capital and R&D investments as well as educational attainment. First of all, Europe needs more new and thriving firms willing to reap the benefits of opening markets and to embark on creative or innovative ventures for commercial exploitation on a larger scale. It is increasingly new and smaller firms, rather than large ones, that are the major providers of new jobs 14 .