This adds additional complexity to the setting of monetary and macro-prudential policies. It is possible to explore this complex interplay using simulations from models comprising both nominal and financial frictions. Both are needed to accommodate a role for monetary policy (whose effectiveness relies primarily on nominal frictions) and macro-prudential policies (whose effectiveness relies principally on financial frictions). A number of models have recently been developed with these core ingredients and have been used to explore monetary and macro-prudential policy interactions (Smets (2013), Paustian and De Paoli (2013)). Chart 18 shows the results of a simulation from a model developed by two colleagues at the Bank (Aikman and Nelson (2014)). This, too, embodies both nominal and financial frictions. On the axes are plotted two measures of stability – macro-economic stability (as proxied by the variability of nominal GDP) on the x-axis, financial stability (as proxied by the variance of  12  More details are available at www.crisis-economics.eu. 13  For more on the Bank’s research agenda, please see http://www.bankofengland.co.uk/research/Documents/onebank/discussion.pdf. 12  BIS central bankers’ speeches  credit spreads) on the y-axis. Historically estimated levels of these two variables, normalised to one, are shown at point A in Chart 18. If we now allow monetary policy to play an active role in stabilising the business cycle, through an optimal policy rule which weights output and inflation deviations from target, we can move the economy to point B.

Moreover, these moving parts are likely to be significantly more tightly-coupled than in the past as a result of financial and global integration. In other words, the global economic and financial system may, over recent decades, have become a “system of systems”, with multiple, interacting layers each a complex system in its own right. Chart 2 provides a stylised characterisation of those layers, decomposed four ways. At the highest resolution – the “micro-prudential” layer – are individual financial firms. These are, if you like, the atoms of the financial system. Like atoms, however, some individual banks are themselves complex entities, with many moving and interacting business parts. At one lower level of resolution – the “macro-prudential” layer – is the financial system. This comprises interactions between financial firms in the network, as might arise from counterparty relationships in interbank, repo and derivatives markets. This layer is akin to an organ, like the brain, whose behaviour is the result of interactions between complex neurological sub-components. At a lower level of resolution still – the “macro-economic” layer – is the national economy. This comprises complex interactions between the financial sector and the wider economy – the flows of funds which intermediates money from owners to borrowers. It is akin to the  BIS central bankers’ speeches  5  physiology of a human, whose behaviour in the result of complex interactions among its organs, themselves complex sub-components. Finally, at the lowest level of resolution of all – the “telescopic” layer – is the global economic and financial system.