rates among their currencies or, even better, by forming a currency union. 4 however, in practice, empirical analyses have generally been unsuccessful at identifying multi - country regions of any size that meet the criteria for an optimum currency area. indeed, some studies have concluded that even the united states and the european union, the largest currency unions, are themselves not optimum currency areas. 5 plausibly, political rather than economic considerations - namely, the desire to form a more perfect union - underlay the decisions of each of these entities to adopt a common currency. 6, 7 besides countries well - suited for a currency union, a second group of countries that might conceivably be better off with a fixed exchange rate, at least for a time, are the very poorest and least developed countries, which may lack the institutional infrastructure to effectively operate an independent monetary policy. in these countries, a hard peg or even the adoption of the currency of a major trading partner - sometimes known as dollarization, although the term also refers to cases in which the currency adopted is one other than the dollar - may be policy options worth considering. ( i want to be clear that i am speaking generally and am not advocating that other countries adopt the u. s. currency. ) although dollarization has the advantage of making monetary policy essentially automatic and should be an effective device for controlling inflation, one is struck by the fact that so few countries have chosen this approach. costs of dollarization include the loss of revenue from money creation and the reduced ability of the central bank to serve as a lender of last resort. but perhaps the most important impediment to dollarization is that, in giving up their own currency, the country ’ s citizens may feel that they are losing an important symbol of the nation ’ s sovereignty and pride. for other developing and emerging - market countries, i would argue that the best course is generally to let the exchange rate float freely and to make low and stable inflation a principal focus of monetary policy. as i have already suggested, this approach makes the targeted inflation rate, and not the exchange rate or some other variable, the nominal anchor of the system. an important reason for making the inflation rate ( more precisely, the price level ) the nominal anchor is that the general price level is more directly linked to economic welfare than is the exchange rate. domestic price stability improves the operation of markets, reduces the costs associated with economizing on money holdings and with

for instance, we have emphasized to banks the importance of stress testing to help detect risks not identified by more - typical statistical models, such as abnormally large market moves, evaporation of liquidity, prolonged periods of market distress, or structural changes in markets. as i noted in a speech last month, financial innovation can benefit consumers, the financial system, and the broader economy, but it also has risks that must be properly understood. 6 indeed, as you know, financial innovations in areas such as structured credit products and mortgage lending in some degree helped precipitate the current crisis. accordingly, we are requiring banks to evaluate more comprehensively the possible unintended consequences of proposed new financial instruments as well as how those instruments are likely to perform under stressed market conditions. counterparty credit risk is another area in which the federal reserve has been working for some time, and, as the crisis has unfolded, we have intensified our monitoring of how firms manage this type of risk. institutions are being pushed to further improve their understanding ben s. bernanke ( 2009 ), " financial innovation and consumer protection, " speech delivered at the federal reserve system's sixth biennial community affairs research conference, washington, april 17. of key linkages and exposures across the financial system. they are also being asked to analyze how their own defensive actions during periods of stress might put pressure on key counterparties, especially when other market participants are likely to be taking similar measures. a critical component of risk management is understanding the links between incentives and risk - taking, such as in the design and implementation of compensation practices. bonuses and other compensation should provide incentives for employees at all levels to behave in ways that promote the long - run health of the institution. the federal reserve has been working in international forums on compensation and incentives issues ; one product of those efforts was the publication last month by the financial stability board of new principles for sound compensation practices. 7 certainly, an important lesson of the crisis is that the structure of compensation and its effect on incentives for risk - taking is a safety - andsoundness issue. in this and other areas, one of the key lessons for bankers has been the need for timely and effective internal communication about risks. we are putting a high priority on ensuring that management and board of directors are well informed about the various risks that confront the organization and that they are actively engaged in the management of those risks. as we have worked with financial institutions to strengthen their governance and risk management,