All considered, the pursuit of macro and financial stability in the context of an inflation target regime may call for some exceptional departure from a fully floating exchange rate and a highly integrated international financial market. This can take different forms, as they may require the use of non-interestrate policy, such as reserve requirements on bank deposits instead of the conventional interest rate policy; a temporary reduction of the degree of financial integration, through the use of some sort of capital controls; or it can allow some exchange rate intervention, through the accumulation of international reserves in order to avoid excessive exchange-rate appreciation. I will comment on each of these options next. Using alternative monetary policy instruments to deal with inflationary pressures, such as reserve requirements on bank deposits, may prevent the undesired credit growth associated with capital inflows without affecting interest rate differentials. This seems to be the case of Turkey, Peru, Brazil, China and India, which have used extensive reserve requirements to deal with inflationary pressures in the current scenario. Other alternative is imposing a levy on foreign exchange borrowing by banks, as the one implemented in South Korea. However, this road is more appropriate when inflationary pressures come from excessive bank credit related to capital inflows than in other cases. When the surge in inflows comes not only from  4  BIS central bankers’ speeches  the banking system, these measures may only create disintermediation and the allocation of excessive risk in other parts of the financial system.

This calls for a revision of this view.2 In my remarks today, I would like to start by discussing some general issues regarding the linkages between price and financial stability and the linkages between monetary and macroprudential policy. In the second part of this talk, I will refer to the context of international capital flows and policy responses in a small open economy with inflation targeting, and the relation that monetary policy has to have with macroprudential policies in that context. Interactions between Monetary and Financial Policies Most central banks care not only about price stability, but also about financial stability. The goal for price stability is usually the main mandate of central banks, and is widely understood as maintaining low and stable inflation, which also reduces the deviations of output from its potential. However, the central bank’s mandate for preserving financial stability is less explicitly defined; probably in part because there is less agreement on what is financial stability and what should be considered an indicator of it. Broadly understood, it encompasses a stable and fundamental-driven credit and asset price growth, as well as the absence of large mismatches in the financial sector. It is not the purpose of my talk to narrow the definition of financial stability, so I will use the term in a broad sense. There is also the key distinction between micro and macro financial stability, and in most of what follows I will be focusing on the systemic aspects of financial stability, unless noticed otherwise.