9  A recent paper, by Charlie Bean, Matthias Paustian, Adrian Penalver and Tim Taylor, “Monetary policy after the fall”, Federal Reserve Bank of Kansas City Annual Conference, August 2010, shows that the monetary policy instrument and macroprudential instrument (a lump-sum levy/subsidy on the banking sector) are not perfect substitutes in a sticky-price New Keynesian macroeconomic model with a banking sector. 10  Charlie Bean et al, ibid. BIS central bankers’ speeches  9  The overlap between macroprudential and monetary policy is one rationale for giving the central bank a prominent role in the setting of macroprudential policy. In addition, many central banks already have some of the analytical skills that will be needed for conducting the policy. However, greater analytical capacity will need to be built up. Analytical tools must be developed to guide policy While we know that there is an overlap between macroprudential policy and monetary policy, we lack models that describe the relationship in much detail. It is a difficult task for a number of reasons: (a) in the models currently used by central banks, financial sectors are poorly modelled, so it is difficult to introduce financial instabilities; (b) developments in financial markets are sometimes driven by psychology, which is difficult to replicate in models with rational agents; (c) the risk of a crisis cannot be modelled in the usual way, as it is more like an extra channel in the transmission mechanism; and (d) policymakers want models that can give them guidance on when to act, which is extremely challenging.

The macroprudential mandate is likely to be broad in scope, as system-wide risks can arise in a wide range of ways and from a wide range of sources. Consequently, the range of macroprudential instruments must be equally broad in scope. Discussions of macroprudential instruments usually emphasise the need for instruments that operate in two dimensions: the time or cyclical dimension, in which instruments are designed to counteract financial multipliers/ accelerators that amplify cycles; and the cross-sectional dimension, in which instruments are required to isolate or dampen the transmission of problems across the financial system. While it is important that the macroprudential agency has control over instruments to prevent and mitigate system-wide risks, it is not essential for the agency to implement these instruments itself. The macroprudential toolkit is likely to include instruments used for other policy objectives and not implemented by the macroprudential agency (for example, capital requirements and insurance premiums). Overlap between policy areas The overlap between different policy areas is one of the major challenges to the design of effective governance arrangements. Responsibility for using instruments that can be used for multiple policy objectives is more complicated and policy-setting is more difficult as policymakers must consider the unintended impact of their instruments on other policy objectives and the unintended impact of other policy-makers’ instruments on their own policy objective. The use of an instrument for one objective may conflict with or amplify the effect of instruments used to achieve a different policy objective.