increased asset values. likewise, reduced risk and volatility may provide an extra kick to capital expenditure in the short run, as firms are more likely to undertake investments in new structures or equipment in a more stable macroeconomic environment. a second issue concerns the role of monetary policy in the management of large swings in stock values, or " bubbles. " in an earlier speech ( bernanke, 2002 ), i gave a number of reasons why i believe that using monetary policy - - as opposed to microeconomic, prudential policies - - is not a good way to address the problem of asset - market bubbles. these included the difficulty of identifying bubbles in advance ; the questionable wisdom, in the context of a free - market economy, of setting up the central bank as the arbiter of asset values ; the problem that arises when a bubble occurs in only one asset class rather than in all asset classes ; and other reasons. a major concern that i have about the bubble - popping strategy, however, is that attempts to bring down stock prices by a significant amount using monetary policy are likely to have highly deleterious and unwanted side effects on the broader economy. the research i have described today allows me to address this issue more concretely. here i will make just two points. first, this research suggests that relatively small changes in monetary policy would not do much to curb a major overvaluation in the stock market. as we have seen, a surprise tightening of 25 basis points should be expected to lower stock prices by only a little more than 1 percent, which, as already noted, is a trivial movement relative to the overall variability of the stock market. it would not be appropriate to extrapolate these results to try to estimate how much tightening would be needed to correct a substantial putative overvaluation in stock prices, but it seems clear that a light tapping of the brakes will not be sufficient. what we can say is that the necessary policy move would have to be quite large - - many percentage points on the federal funds rate - - and we would be highly uncertain 15 16 about its magnitude or its ultimate effects on stock prices and the economy., there is a bit more to this analysis. an additional complexity arises from the fact that, although easier monetary policy allows consumers to enjoy a capital gain in their stock portfolios today, it also " takes back " some of that gain, so to speak, by affording shareholders a lower rate of return on their holdings, on

projections that foresee even higher prices in the near future. as a matter of fact, many countries under inflation targeting regime now project that inflation will converge to the target at end - 2009 or in 2010, at the earliest. going through a long period of high inflation is a serious risk for price stability. first, the general price level may shift upwards at a faster rate, as producers and workers in other sectors ask for higher prices and wages in response to the loss of their real purchasing power. the fall in real interest rates due to deterioration in inflation expectations is another risk, since lower real rates will lead to a faster pace of credit expansion. the common factor of these two risks is that persistent supply shocks may turn into demand shocks after a while. thus, at some point, central banks have to decide to what extent they can tolerate the rise in inflation. as the famous philosopher karl popper put it while defining the demarcation problem, “ if we do not demarcate a scientific hypothesis, we will be leaving out one of the key steps in verifying the correctness of that hypothesis ”. any theory should be formulated in a way to allow falsification ; the circumstances under which the theory fails should be identified. advocators of a “ wait - and - see ” approach in the face of supply shocks are not clear on the question of when the supply shock ends and when demand - driven price increases take its place, in an environment where inflation keeps rising. if this issue is not clarified, any abovetarget inflation figure or any upward revision in inflation forecasts can easily be attributed to supply - side factors. clear lines should be drawn as to which economic data would refute this discourse and what would constitute a limit to supply shocks from a central banker ’ s point of view. dear guests, in this part of my speech, i would like to discuss recent developments in the turkish economy and the monetary policy implemented in this period. i believe that starting this evaluation with the developments in 2006 will be more useful in providing a better understanding of the current monetary policy stance. as you may know, in may 2006 risk perceptions for developing countries changed significantly owing to the deterioration in global liquidity conditions. in the period where the supply - side shocks started to take their toll on inflation, the rapid depreciation of turkish lira led to a significant deterioration in medium and long - term inflation expectations – giving rise to the risk of potential second - round impacts. the central bank