6 Second, the “twin engines” view draws too absolute a line between banks and non-bank financial intermediaries. Alongside other asset managers, banks have been material investors in securitised credit. In some respects, it may be more useful to distinguish  4  See Churm R., and L. Webber (2007), “Decomposing corporate bond spreads”, Bank of England Quarterly Bulletin, Q4 2007 (forthcoming). 5  Alan Greenspan made this point a few times. 6  For example see Tucker P M W (2007), “A perspective on recent monetary and financial system developments”, speech at Merrill Lynch Conference on Hedge Funds, Bank of England Quarterly Bulletin, Q3 2007, pp 310-16. BIS Review 149/2007  3  between intermediaries on the basis of whether they undertake some combination of maturity transformation, leveraging their balance sheets, and mark-to-market valuations. Banks are not alone in having these characteristics, and so there can be common shocks to bank and non-bank investors. In a recent series of papers, 7 Hyun Shin has argued that balance sheet management of this kind amplifies the credit cycle. That sounds like the “financial accelerator” model, except that Shin’s position is that the outcomes can exceed those warranted by fundamentals. His argument is that in the upswing of a business cycle, the rise in asset values increases the accounting net worth of banks and other intermediaries, enabling them to leverage up their balance sheets. This expands credit; and increases the liquidity in capital markets, reducing liquidity premia embodied in asset prices; and so on.

International inflationary impulses are generated via prices for imported consumer and intermediate goods. These inflationary impulses will partly be influenced by developments in international commodity and consumer prices and by the exchange rate. Interest rates influence inflation through their impact on domestic demand and on the market for NOK. When interest rates rise, it is more profitable to save and more costly to borrow. This dampens consumption and investment and hence aggregate demand. Lower demand in turn curbs the rise in prices and wages. Higher interest rates make it more attractive to take krone positions and borrow in foreign currency. As a result, higher interest rates normally lead to an appreciation of the krone. This reduces prices for imported goods. In addition, a strong krone reduces activity and profitability in the internationally exposed sector. It is important to be aware of the relationships between employment, output and inflation. If there is a shortage of labour and other economic resources, a tight monetary policy stance will reduce inflation by affecting aggregate demand. Conversely, when unemployment is high, low interest rates stimulate demand, which will contribute to stable wages and prices. A monetary policy stance that is aimed at stabilising inflation will thus also contribute to stabilising aggregate output and employment. In the long term, monetary policy determines the average level of inflation. Output is determined by the supply of labour, capital and technology and by productivity growth. Attempts to increase output beyond the total capacity of the economy will lead to inflation in the long run.