Bernanke, B., M. Gertler, and S. Gilchrist (1999), “The Financial Accelerator in a Quantitative Business Cycle Framework”, in John B. Taylor and Michael Woodford (eds.) Handbook of Macroeconomics, edition 1, volume 1, pp. 1341-1393. Elsevier: Amsterdam. Borio, C. and H. Zhu (2008), “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?” BIS Working Paper 268. Brazier, A., R. Harrison, M. King, and A. Yates (2008), “The Danger of Inflating Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping-Generations Monetary Model”, International Journal of Central Banking, 4(2), 219-254. Broadbent, B., (2012), “Deleveraging”, speech available at www.bankofengland.co.uk/ publications/Documents/speeches/2012/speech553.pdf. Caballero, R., (2010), “Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome”, MIT Department of Economics Working Paper No. 10–16. Curdia, V., and M. Woodford, “Credit Frictions and Optimal Monetary Policy,” working paper, Federal Reserve Bank of New York, August 2009. Eichengreen, B., M. El-Erian, A. Fraga, T. Ito, J. Pisani-Ferry, E. Prasad, R. Rajan, M. Ramos, C. Reinhart, H. Rey, D. Rodrik, K. Rogoff, H. Shin, A. Velasco, B, Weder di Mauro, and Y. Yu (2011), “Rethinking Central Banking,” Brookings Institution, Washington. Eggertsson, G., P. Krugman “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach”, The Quarterly Journal of Economics (2012) 127(3): 1469– 1513. Fisher, I., (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, no. 4. 18  BIS central bankers’ speeches  Geanakoplos, J., (2010), “The Leverage Cycle.” In D. Acemoglu, K. Rogoff, and M. Woodford, eds., NBER Macroeconomics Annual 2009, vol. 24, 1–65. Chicago: University of Chicago Press.

4  BIS central bankers’ speeches  Existing models, then, do not tell us why stability today may come at the expense of instability tomorrow. Perhaps we should heed the advice of Ricardo Caballero, who has written that “macroeconomic research has been in ‘fine-tuning’ mode within the local maximum of the dynamic stochastic general equilibrium world, when we should be in ‘broad-exploration’ mode”. 14 So let me now move into broad exploration mode and give three examples in which a trade-off between monetary and financial stability might arise, and which could in theory justify a policy of aiming off the inflation target in order to reduce the risk of future financial instability, before I turn to whether such a policy would have been appropriate before the crisis. The first is where misperceptions about future incomes persist and are embodied in key prices, such as the exchange rate and long-term interest rates. Households, businesses, and banks can all make big mistakes when forming judgements about the future, and make spending decisions today which they will come to regret when their true lifetime budget constraints are revealed. There is no mechanism for ensuring that misperceptions about the sustainable level of spending are corrected quickly. It may take many years before those beliefs are invalidated by experience. So an equilibrium pattern of spending and saving can emerge that is stable temporarily but not sustainable indefinitely. And misaligned prices may reinforce mistaken beliefs if people are using market prices to extract signals about future incomes and consumption opportunities.