Indeed the key results of Tobin’s and Markowitz’s work are labelled the “benefits of portfolio diversification”. Managers and academic economists have long been aware of the necessity of taking risk, as well as returns, into account when making portfolio decisions. The first pioneering contributions on money and asset pricing were therefore made in the 1950s, with the analysis focusing on the case of a closed economy. In this setting, for given risks, a rise in the expected excess returns implies a lower demand for money. In the course of the last 20 years, the globalisation of financial markets owing to the reduction of transaction costs and the enhancement of information flows has increased the share of global wealth invested outside investors’ home jurisdictions. The models of Tobin and Markowitz have become, therefore, much more complicated when extending the analysis to the global environment. Portfolio theory suggested that assets should be considered imperfect substitutes for each other, with the differences in their expected yields reflecting their marginal risks regardless of the economy being open or closed. However, the representative agent model is no longer applicable in the case of an open economy, as the presence of international capital flows requires either asymmetric information or heterogeneous belief among various agents. This makes the theoretical and empirical efforts to search for policy solutions a very complicated business. In an open economy setting, for given risks, a rise in expected excess returns does not necessarily imply a lower demand for money.

The growing size of international capital flows associated with globalisation of financial markets has made the analysis of monetary aggregates, for the purpose of extracting information for assessing price stability, increasingly more complex. BIS Review 149/2007  3  This brings me to discuss the third point: the implications of globalisation and of international capital flows for monetary policy. If globalisation and, specifically, cross-border capital flows can affect the dynamics of monetary aggregates, how can we conduct monetary policy? An improved shared understanding of the influence of global liquidity and cross-border capital flows on the monetary policy transmission mechanism is necessary to enhance the analysis underlying our decisions. Our role and responsibilities as central bankers remain intact in the globalised economy, but the performance of our task may be becoming more challenging. Certainly, there is a need for timely and open exchange of information among central banks and for further collaborative research efforts. Still, let me stress that the globalisation of financial markets does not affect the central role and overriding responsibility of central banks, which is to preserve price stability within their respective jurisdictions. Central banks throughout the world have been assigned responsibility for keeping domestic inflation at low and stable rates. Cross-border capital flows may affect the velocity of money, but the basic principle for anchoring monetary policy – that is the Friedman’s view that “…in the long run, inflation is always and everywhere a monetary phenomenon” – remains valid.