than waiting to “ mop ” up after the bust? certainly we have seen that monetary policy cannot fully offset the effects of financial crises for two reasons. first, crises may impact output before the response of monetary policy is felt. second, crises typically reduce potential supply growth, for example by disrupting the supply of credit to productive firms. a failure to take financial instability into account creates an unduly optimistic view of where the taylor frontier lies, especially when it is based on data drawn from a period of stability. relative to a taylor frontier that reflects only aggregate demand and cost shocks, the addition of financial instability shocks generates what i call the minsky - taylor frontier, shown in chart 5. this reflects the influence of misperceptions, financial cycles and the search for yield. on the minsky - taylor curve, for a given degree of inflation variability, output is more volatile in the long run than on the simple taylor curve. ignoring financial instability might mean choosing a policy reaction function that is believed to imply a trade - off at point o in chart 5. in fact, the true trade - off is given by point p. once that is understood then the optimal policy reaction function might well change and correspond to a trade - off at point q. 22 the examples i have given suggest the possibility that there is a trade - off between meeting the inflation target in the short run and reducing the risk of a financial crisis in the long run. to shed light on whether that possibility warrants a change to the way we implement inflation targeting, i want now to conduct a counter - factual thought experiment and ask whether monetary policy before 2007 might have moderated the crisis if it had not simply pursued a target for inflation. a counter - factual monetary policy 1997 – 2007 i want to ask whether, with the benefit of hindsight, monetary policy should have been set differently during the period of the so - called great stability. should interest rates have been higher during that period in order to mitigate some of the growth of credit, rise in asset prices, and increase in the leverage of the banking system? many commentators today seem to think that the answer is clearly yes – though i seem to remember that fewer said so at the time – and most of the another mechanism, working through banks ’ leverage, is posited by adrian and shin ( 2011 ). they show that if banks target a value - at - risk constraint, then monetary policy loosening can increase risk taking. the reduction in policy

a floor for the minimum level of foreign exchange reserves a country is required to maintain ; ( ii ) the aim of resolution is to find a cooperative solution negotiated between a debtor and its creditors. no particular class of creditor should be in a privileged position, unless the instrument in question explicitly gives it preferred creditor status ; ( iii ) the use of temporary standstills – possibly sanctioned by the international community – would allow time for a country to negotiate with its creditors. in the absence of a formal mechanism to achieve this, the imf can indicate its endorsement of a standstill by being prepared to provide new money to a country which has temporarily suspended payments to its creditors ( often referred to as imf lending into arrears ). by making standstills part of the furniture – or one of the bricks – they would be seen not as an ad hoc response, which might lead to contagion in other emerging markets, but part of an approved process ; ( iv ) measures, including perhaps strictly temporary capital controls, to prevent capital flight by domestic residents in exceptional circumstances. it would be odd to sanction a standstill of payments to foreign creditors while allowing domestic residents to move assets overseas without restriction. the essence of the middle way is to find practical steps forward to enable emerging markets to better manage the liquidity positions of their external liabilities, and to reduce their dependence on debt finance. crises will still occur. but the aim is to reduce their frequency and severity. to that end there is one further policy which is fundamental to the success of the middle way – transparency. 5. transparency transparency is one of the most popular words in economic policy today. and for good reason. much has been said about transparency, and, interestingly, much has been done. why is transparency so important? in itself, transparency will neither prevent nor resolve financial crises. but transparency can help reduce the frequency of crises – by alerting not only markets but also policymakers to problems on the horizon – and their severity – by minimising the surprises about the scale of any liquidity problems. in korea, the foreign currency exposure of its banking system was not known until after the crisis had hit. and in thailand, the true state of the foreign exchange reserves was unknown even to its own finance ministry, let alone financial markets. so transparency can be seen as a “ second best ” policy when purist solutions to financial crises are unavailable. it is in the context of the middle way that transparency