decisions and in some way take into account the risks it envisages. in the description of the framework for the riksbank ’ s monetary policy, which we published recently it says : “ the riksbank routinely takes into consideration changes in asset prices and other financial variables ( exchange rates, house prices, share prices, household and corporate indebtedness, etc. ) in monetary policy decisions. this should not be interpreted as introducing targets for different asset prices or other financial quantities. however, situations may arise where the consequences for the real economy and inflation of the development of different financial variables threaten to become very unfavourable and serious without it being possible for that reason to quantify or capture this type of risk in the normal analytical and forecasting work. this means that there are risks of sharp corrections in the future which in turn affect the real economy and inflation. it may be necessary to take these risks into account in monetary policy decisions in a different way than in the normal approach, where the forecasts for inflation and the real economy for the next two years serve as the foundation. ” although it is difficult to quantify the risks related to strong and long - term growth in asset prices and debts using normal methods, there is a fairly large flora of research into how different types of imperfections can cause and reinforce the types of imbalances i have discussed. one research area, for instance, is based on psychological factors being able to lead to expectations becoming an independent driving force behind fluctuations in the real economy. if, for instance, the real return on a financial asset has been high over a long period of time, this may, according to some research results, affect expectations so that many believe that the return will be as high in the future, despite fundamental factors indicating a lower return. in efficient financial markets, the agents with forwardlooking rational expectations should be able to earn money by taking offsetting positions, but an unwillingness to take risks, difficulties in finding financing or regulations can mean that this is not possible to a sufficient extent. there are for example empirical studies indicating that investors appear to disregard the fact that an economic upswing is usually followed by a downswing and vice versa, which leads to them tending to take greater risks than they should in an upswing and vice versa in a downswing. another research area concerns imperfections in the credit markets, which lead to the current income and balance sheet having significance for consumption and investment, as lenders and borrow

. it is questionable whether a straightforward and stable relationship between the money supply and inflation also exists in the short and medium term. this is because the relationship has been disturbed by various factors. financial innovations have contributed, for example, to changes in the pattern of household payments and investment. moreover, a number of major factors still have to be forecast in order to arrive at what may be an appropriate target for the money supply. so in practice even a money supply strategy has to be based on forecasts of a number of variables and an assessment of, for example, the output gap. moreover, when the strategy was used in a number of countries in the 1970s and ‘ 80s, it was not particularly successful. in the absence of a straightforward, stable relationship between the intermediate variable ( the money supply ) and the ultimate objective ( price stability ), a conflict may arise between them because the central bank has only one instrument, its interest rate. if the central bank chooses the minimise fluctuations in the money supply, a probable consequence – given that the relationship is not exact or stable – will be increased fluctuations in inflation and output. it is intuitively hard to see why a central bank would prefer to stabilise the money supply, which does not directly affect public prosperity, rather than stabilising price movements and output more directly. if the relationship between the money supply and inflation is not exact and stable over time, the significance of the money supply should be demoted to that of one of several indicators in an inflation targeting strategy based on forecasts. while the money supply is an important indicator of inflationary pressure, it is not the only one. there may be grounds, on the other hand, for highlighting the significance of the money supply ( or rather perhaps its mirror image of the loan stocks in bank balance - sheets ) as a source of information about the financial system ’ s future stability. in the past, the build - up of a sizeable financial bubble has nearly always coincided with a major expansion of credit in the financial system. sweden ’ s bank crisis about a decade ago is a case in point. against this background, the money supply and credit flows should belong to the arsenal of indicators of both monetary and financial stability that a central bank ought to follow closely. inflation and the output gap yet another alternative way of conducting monetary policy is to set the interest rate as a function of the rate of price increases and some measure of the difference between actual and potential growth. professor john taylor, currently a treasury