seppo honkapohja : how did the crisis challenge the central banking as we knew it? what should ( not ) change? remarks by mr seppo honkapohja, member of the board of the bank of finland, at the conference on “ financial and macroeconomic stability : challenges ahead ”, istanbul, 4 – 5 june 2012. * i. * * introduction the on - going financial crisis brought about realizations of “ tail risks ”, which has forced a serious rethink on several dimensions of central banking. the most obvious challenge is the greatly increased importance of financial stability objective that has come about as a result of the banking and financial market problems during the crisis. it is evident that financial stability objectives will also have a bearing on the conduct of monetary policy. there has been a fair amount of new research on the interrelations between financial stability and monetary policy and significant research effort is ongoing in this area. as the next speaker in the panel is an expert in the financial stability area, i will not focus on these issues in my remarks. instead i will take up three other consequences of the crisis and their influence on the practices of central banking. in my opinion these areas are important for both macroeconomic policy and research. 1. the great recession of 2008 – 2009 was combated with the use of some strong monetary policy measures, together with fiscal stimulus policies. some new forms of monetary policy have been used. what do we know about their effects and effectiveness? is there a need to keep these new policies in the tool kit of central banks in the longer term? 2. the recession has been followed by sluggish recovery in many advanced market economies. the current situation is placing a very large role for monetary policy. this is straining the usual boundaries between monetary and fiscal policy. 3. the fiscal deficits led to rapidly rising levels of public debt, which are now a huge concern. though the levels of public debt were rising in many advanced market economies before the crisis, the great recession accelerated the public debt problems. the high public debts are a concern more generally and not just in the euro area. these debt problems are likely to pose a challenge for defining the proper domains of fiscal and monetary policies in the coming years. ii. monetary policies to combat the crisis when the crisis became acute the initial response of most central banks took the form of rapidly executed reduction in the policy interest rate. when the policy rates reached an effective lower bound, central banks had to

current financial crisis has brought the financial stability tasks to the discussions of central banking objectives and practices. new frameworks and tools for macro - prudential supervision and new regulations on the financial system have taken a central position on current policy and research agendas. this development has come as a response to the financial crisis. price stability as the macroeconomic objective continues to play an important part in central banking. inflation targeting with a credible and independent central bank may well survive as the framework for monetary policy. however, interconnections between financial and macroeconomic stability are one topic that needs more attention in the future. redrawing the boundaries between fiscal and monetary policy is a second topic that needs attention in the future. there are two reasons for this. first, the roles of fiscal and monetary policy in the great recession and in exit from the current stagnation need further assessment. second, the sovereign debt crisis and the rising debt levels in many advanced market economies may well influence the boundaries between monetary and fiscal policy in the coming years. references benhabib j., g. w. evans and s. honkapohja ( 2012 ), liquidity traps and expectation dynamics : fiscal stimulus or fiscal austerity?, nber working paper nr. 18114. brunnermeier m. k., t. m. eisenbach and y. sannikov ( 2012 ), macroeconomics with financial frictions : a survey, mimeo, march. christiano l., m. eichenbaum and s. rebelo ( 2011 ), when is the government spending multiplier large?, journal of political economy, vol. 119, 78 – 121. fernandez - villaverde j., g. gordon, p. a. guerron - quintana and j. rubio - ramirez ( 2012 ), nonlinear adventures at the zero lower bound, nber working paper nr. 18058. bis central bankers ’ speeches gertler m. and p. karadi ( 2012 ), qe 1 vs. 2 vs. 3 … a framewrok for analyzing large scale asset purchases as a monetary policy tool, mimeo, march. reinhart c. m. and m. b. sbrancia ( 2011 ), the liquidation of government debt, nber working paper nr. 16893. bis central bankers ’ speeches