This has produced asset bubbles and large exposures of banks from core euro area countries, as well as world-wide creditors, towards the euro area periphery, and created strong contagion channels that have increased the amplitude of swings in comparison to historical business cycles. Such a phenomenon has in quite a few instances also been observed outside of the euro-area, regardless of the exchange rate regime implemented, which brings me to the discussion of challenges in finding an optimal policy mix in a small open economy. 2. Mutations of the traditional monetary trilemma: policy responses in open economies or “Ray in European clothing”  According to the newly emerging set of principles, this dual central banks’ mandate is supposed to function via two independent sets of policies. As real and financial cycles diverge, central banks need a set of two independent policies. 11 Monetary policy should target the real cycle in order to stabilize inflation, while macroprudential policy should be used to tame the financial cycle. The task of maintaining price stability and financial stability should be even easier if central banks adopt a flexible approach to inflation targeting, the one that allows for temporary deviations and the gradual convergence towards the inflation target, as pointed out by Stanley Fischer (2010) 12. Such a simple story of two independent policies – monetary and macroprudential – aiming at two separate goals, has some weaknesses. Such a framework is underlined by the traditional monetary trilemma theorem launched by the Mundell-Fleming model.

The traditional monetary trilemma limits policy choice to only two among the three dimensions: independent monetary policy, free capital mobility and exchange rate stability. However, the usefulness of exchange rate flexibility as the shock absorber has been increasingly questioned over time. A more sceptical view on the usefulness of flexible exchange rates has changed the trilemma into an “irreconcilable duo: independent monetary policies are possible  9  Gros, Daniel. (2011) What is holding Italy back?, CEPS Commentary, 8 November 2011. 10  Hassan F., G. I. P. Ottaviano (2013), Productivity in Italy: the great unlearning, VoxEU.org, 30 November. 11  Constâncio, 2015. ibid. 12  Stanley Fischer (2010): Myths of Monetary Policy, Israel Economic Review, 2010. 4  BIS central bankers’ speeches  if and only if the capital account is managed” (Ray, 2013) 13. Those who believe that exchange rate flexibility should not be abandoned, even in the cases of small open economies, have largely deflated their expectations of flexible exchange rates to act as shock absorbers 14. Therefore, the notion that “the global financial cycle constrains national monetary policies regardless of the exchange rate regime” has now become part of common knowledge. With supranational “one-size-fits-all” monetary policy, the role of national fiscal policy in stabilizing real activity and inflation has, accordingly, increased in euro-area member states. However, the configuration of single monetary policy, coupled with national fiscal sovereignty and the no bail-out clause, has generated suboptimal policies and frictions that threaten the monetary union.