If the central bank uses all relevant information in constructing these forecasts , including the impact of changes in financial conditions on inflation and resource utilisation at any horizon, monetary policy will automatically respond in the best possible way to changing financial conditions (Woodford 2007, 2010a). One lesson from the financial crisis is that financial conditions may in times of crisis have a strong and deteriorating effect on the transmission mechanism, making standard interest-rate policy less effective. This motivates more research on how to incorporate financial conditions and financial intermediation into the standard models of the transmission mechanism used by central banks. Much progress has already been made in understanding these effects (see Adrian and Shin 2010a, Gertler and Kiyotaki 2010 and Woodford 2010a). The relation between monetary policy and financial-stability policy As mentioned, an important conclusion from the financial crisis is that neither price stability nor interest-rate policy are enough to achieve financial stability (Carney 2009, White 2006). Good flexible inflation targeting by itself does not achieve financial stability. Furthermore, the policy rate is an ineffective instrument for influencing financial stability, and policy rates high enough to have a noticeable effect on credit growth and house prices will have a strong negative effect on inflation and resource utilisation, even in sectors that are not experiencing any speculative activity. Specific policies and instruments are needed to ensure financial stability. A good financial-stability policy framework is necessary to ensure financial stability. Monetary policy cannot serve as a substitute.

The less sloped straight line is an iso-loss line that corresponds to equal weight on inflation and output-gap stabilization, that is to a “lambda” equal to one. 4 With such equal weight, the high policy-rate path is preferred. The steeper straight line corresponds to lambda equal to 0.3, that is, with a weight on output-gap stabilization equal to 0.3 relative to the weight on inflation stabilization. With such a weight, the main policy-rate path is about as good as the higher and clearly better than the lower policy-rate path. At the time, Norges Bank had announced that its decisions were consistent with a relative weight on output-gap stabilization equal to 0.3 and a relative weight on interest-rate smoothing of 0.2 (Bergo 2007 and Holmsen, Qvigstad, and Røisland 2007). With some weight also on interest-rate smoothing, the main policy rate is best. The use of the mean squared gaps is one more step towards more systematic and transparent inflation targeting, in which central banks can be evaluated and held responsible for their decisions with even greater accuracy than before, following the introduction of numerical inflation targets, published forecasts of inflation and the real economy, published policy-rate paths and other important steps taken in the development of a systematic and transparent monetary policy. References Adrian, Tobias, and Hyun Song Shin (2010a), “Financial Intermediaries and Monetary Economics,” in Friedman, Benjamin M., and Michael Woodford (eds. ), Handbook of Monetary Economics, Volume 3, Elsevier, forthcoming.