##bitrage relationships, leaving them incapable of explaining recent developments in both credit volumes and risk premiums. economists at central banks and in academia will need to devote much effort to overcoming these deficiencies in coming years. however these models are adapted, recent events suggest that central banks should be wary of placing too much faith in model - based analyses, which are necessarily predicated on past empirical correlations and relationships. as we have seen, financial innovation can induce structural changes that can importantly alter the way financial institutions, markets, and the broader economy respond to shocks. for this reason, policymakers should take a critical approach to evaluating analyses of this sort, and should always probe to find the sensitivity of results to unstated assumptions that may no longer be valid. given our limited understanding, the first line of defense against systemic risk must be building more robust and resilient financial systems. private parties are doing a great deal to increase capital and liquidity and enhance risk - management practices. but policymakers must also adapt their supervisory and regulatory structures to promote a robust financial system that can withstand occasional shocks, even severe ones, without systemic problems that become destabilizing. we must ensure that financial firms – especially those central to the functioning of our highly interlinked markets – have sufficient capital, liquidity, and management resources to back financial intermediation activities both on and off their balance sheets. another important consideration should be to make sure that our regulatory policies do not exacerbate credit and business cycles. and we should be considering ways to promote transparency that would enhance market functioning and the ability of investors to bring their own discipline to bear on decisions to buy and sell. a central challenge will be to structure financial oversight to both deter unwanted and excessive risk - taking and permit the innovation that can ultimately boost economic growth. because central banks are ultimately responsible for financial stability, they must work closely with legislators and with other supervisory authorities at home and abroad to ensure that these goals are met. can the conduct of monetary policy also be adapted to reduce the odds of systemic financial events, and should the manipulation of short - term interest rates take account of the potential for imbalances and price bubbles as well as the traditional objectives of price stability and economic growth? here i think the lessons of the current episode need to be studied further. before the recent experience, i believed that the appropriate strategy for conventional monetary policy was to focus exclusively on the stability of economic activity and overall prices for goods and services over the next

different set of forces that mold the development of discount factors which, together with earnings projections, produce estimates of market value. first, the rapid shift in the composition of gross domestic product towards idea - based value added is muddying our measures of current earnings and, hence, our projections of future earnings. the key definitional question that must be confronted is, what is a capital outlay? conversely, what is an expense that, by definition, is consumed in the process of production and deemed an intermediate product? this issue is most immediately evident in accounting for software outlays, but it is rapidly expanding to a much broader range of activities. software that is embedded in capital equipment, and some that is stand - alone, is currently being capitalized and consequently amortized against current and future earnings. but a substantial portion of software spending is expensed, even though the equity prices of the purchasing companies are clearly valuing the software outlays as contributing to earnings over their useful economic lives – the relevant criterion for capitalizing an asset. there has always been a fuzzy dividing line between what is expensed and what is capitalized. this has historically bedeviled the accounting for research and development, for example. but the major technological advances of recent years have exposed a wide swath of rapidly growing outlays that, arguably, should be capitalized so that the returns they produce would be more accurately reflected as earnings over time. indeed, there is even an argument for capitalizing new ideas, such as different ways of organizing production, that enhance the value of a firm without any associated outlays. some analysts judge the size of undercapitalized outlays as quite large. 1 the important point, however, is that decisions about which items to expense will have important consequences for reported earnings. in general, if the trend of expensed items that should be capitalized is rising faster than reported earnings, switching to capitalizing these items will almost always accelerate the growth in earnings. the reverse, of course, is also true. but the newer technologies, and the productivity and bull stock market they have fostered, are also accentuating some accounting difficulties that tend to bias up reported earnings. one is the apparent overestimate of earnings that occurs as a result of the distortion in the accounting for stock options. the combination of not charging their fair value against income, and the practice of periodically repricing those options that fall significantly out of the money, 2 serves to understate