you believe! should monetary policy react directly to exchange rate movements or should it only focus on inflation and real gdp? it is often asserted that the more we integrate global markets, the more we have to sit back and let markets work. can central bankers in small open economies faced with unprecedented capital flows afford to do just that? how interventionist should a central bank be under such circumstances? how resilient are our monetary policy frameworks? do we need more sophisticated economic and monetary models to address the monetary policy challenges stemming from globalization? with globalization, small open economies receiving unprecedented capital flows face the daunting task of managing these external flows in order to ensure macroeconomic and financial stability. monetary management has to contend with the vicissitudes of capital flows and the increased volatility in exchange rates. while the distinction between short - term and long - term capital flows may be conceptually clear, from an operational viewpoint, there are severe problems in distinguishing between the two. at any given time, some of the inflows could be of an enduring nature whereas others could be temporary and, hence, reversible. in the face of such uncertainty in determining the temporary or permanent nature of inflows, is it justified to blame your central banker if, out of prudence, he assumes that the flows are temporary until their permanent nature can be established? there are some underlying similarities in the challenges faced by india and mauritius in the face of capital inflows. there is also, however, a very significant difference in that. india does not have full convertibility of the capital and financial account of the balance of payments. this difference translates into some additional leeway for the reserve bank of india in managing capital flows. mauritius with its open capital and financial account, since the abolition of all capital controls in july 1994, does not have some of the tools which rbi has at its disposal. introducing capital controls under any guise is certainly not an option for us. part iv : challenges for monetary policy what, then, are the challenges faced by a small open economy in the conduct of monetary policy when confronted by unprecedented capital flows? as i said in my opening remarks, this is a question which has been troubling me ever since i took the helm of the bank of mauritius one year ago. as most of you are no doubt aware, in economics, simultaneously targeting an exchange rate and maintaining an independent monetary policy, with an open capital account, is considered an impossible trinity. this famous

an important mechanism for describing the forward - looking view though it should continue to evolve from a binary pass - fail world into one where it is a toolkit to test a range of possible future states of the world and thereby judge the wider resilience of firms. the pra will exercise judgement in the supervisory actions it takes, so that firms are likely to be able to meet its objectives, policies and rules over the medium term horizon. firms will need to demonstrate to the pra that they are robust to a variety of states of the world, including unanticipated stress scenarios. however, since it is not possible for any forecast to cover all possible outcomes, there will always be some probability of firms failing. working with the bank of england ’ s resolution team, the pra will need closely to integrate recovery and resolution planning within its supervision ; and in my view should embed a proactive intervention framework akin to the us prompt corrective action within its supervisory approach to deal with the inevitable situations where firms get into the danger zone. above all, these tools should support competition in the industry, by accepting that there will be winners and losers. in two years ’ time, we will have a new system of financial regulation in the uk. those of us involved can assure you that the transition is not a small task, but i can also assure you that the bank is fully committed to working with the fsa to ensure a smooth transition. there is a great deal to be done to implement the new system of regulation, to articulate and build the public interest in financial stability, and thereby to improve the stability of the system itself. basel iii, macroprudential tools, countercyclical buffers, are all things that adair and i get excited about. they are important foundations of good policy. but on their own they don ’ t win the public interest argument for financial stability. to do that, we have to build the case that the industry will serve the needs and interest of the public. the authorities cannot do this alone. building confidence in the financial system takes effort and time. it is a common goal and in the interest of everyone. lord mayor, the government of the city of london is an important part of the fabric of financial services, and we appreciate all that you do to support the industry and the objective of stability in the financial system. it is therefore my great pleasure to propose a toast to the lord mayor and lady mayoress.