To be more precise, it is the yield curve of both the home and the foreign country, and thus the monetary policies of both the home and the foreign country which affect the exchange rate between two currencies. In practice, exchange rate movements often deviate significantly from what interest rate differentials would suggest. In light of the practical uncertainties about the effects of monetary policy on exchange rates, the exchange rate transmission channel for monetary policy is also not easily exploitable. Other assets Apart from bonds and exchange rates, monetary policy also affects the stock market. The relationship between monetary policy and stock prices is complex, because stocks are influenced by monetary policy through several channels. First, if stocks are priced using the dividend discount model, then monetary policy affects stock prices via the interest rate which is used to discount future dividends. Interest rates may also affect the value of domestic assets of a company, and the exchange rate affects the value of its foreign assets and foreign profits. In addition, monetary policy influences the financing cost of a company as well as the availability of loans. Moreover, the medium-term effects of monetary policy on the real economy can influence a firm's profits. Monetary policy can also affect commodity prices. Expansionary or restrictive monetary policy supports or weakens real activity in the medium run and can thus influence the demand and the price for commodities. Obviously, this dynamic can only occur in economies large enough to impact the global demand for commodities.

Rather, in most cases, many institutions act more or less similarly, encouraged by overoptimistic expectations that macroeconomic conditions can be extrapolated uncritically into the future. The second problem with prudential regulation is that the tools are themselves often based on perceptions of risk which are not independent of the credit and asset price cycle itself. On the one hand, underlying actual risk  BIS Review 68/2002  1  builds up as expansion and leverage continue and the financial cycle proceeds On the other hand, apparent risk declines with the rise in collateral values. This causes difficulties for supervisors who tend to concentrate on individual institutions and treat risks as exogenous. This is not to deny that by improving prudential regulation, setting international standards (for example Basle II) etc, the risk of financial instability can be significantly reduced. Supervisors are also recognizing the shortcomings I just mentioned and are increasingly focusing on developments that generate systemic macroeconomic risks and on constructing built-in mechanisms to dampen the financial amplification of the business cycle. For example, supervisors are trying to encourage stress-testing by private sector risk managers to enable them to better see through asset market misalignments. Another way is to make provisioning practices more forward-looking than at present and to adopt more conservative, less cyclically sensitive measures of value. The idea is to build capital cushions in good times that can be used in bad times. Hence financial cycles could be milder.