to which debt rather than equity is financing the level of capital. the proper degree of leverage in a firm, or in an economy as a whole, is an inherently elusive figure that almost certainly changes from time to time. clearly, firms find some leverage advantageous in enhancing returns on equity, and thus moderate leverage undoubtedly boosts the capital stock and the level of output. a sophisticated financial system, with its substantial array of instruments to unbundle risks, will tend toward a higher degree of leverage at any given level of perceived underlying economic risk. but the greater the degree of leverage in an economy, the greater its vulnerability to unexpected shortfalls in demand and to other miscalculations. although the fears regarding business leverage have been confined mostly to specific sectors in recent years, concerns over potential systemic problems resulting from the vast expansion of derivatives have reemerged with the difficulties of enron. to be sure, firms like enron, and long - term capital management before it, were major players in the derivatives markets. but their problems were readily traceable to an old - fashioned excess of debt, however acquired, as well as to opaque accounting of that leverage and lax counterparty scrutiny. swaps and other derivatives have been remarkably free of default throughout their short history, including over the past eighteen months. of course, latent problems may exist in any market that expands as rapidly as these markets have. regulators and supervisors are particularly sensitive to this possibility. derivatives have provided greater flexibility to our financial system. but their very complexity could leave counterparties vulnerable to significant risk that they do not currently recognize, and hence these instruments potentially expose the overall system if mistakes are large. in that regard, concerns have been raised about potential counterparty risks in the large interest rate hedging efforts of government - sponsored enterprises ( gses ) in support of their secondary mortgage market operations. presumably, counterparties can manage this risk effectively through the use of credit limits, netting, and collateral agreements. the broader risks for financial markets and the economy result from the perception of government support for these corporations and the resulting implicit subsidization of gses. subsidies, by intent, distort the normal balance of markets. in this case, the perception of government support may induce the counterparties of gses to apply less vigorously some of the risk controls that they apply to manage their over - the - counter derivatives exposures. more generally, we need to be careful not to allow subsidies to unduly disturb

inflation – which may be summarised under the heading of the new keynesian phillips curve ( nkpc ). according to this – now mainstream – building block of modern macro models, current the fact that the recycling of oil revenues plays a more supportive role for oil - importing countries today than during past oil price shocks has been confirmed for germany by research undertaken at the bundesbank ( bundesbank, 2005 ). another channel of recycling oil revenues is provided by financial investment opportunities in the capital markets of oil importers. the latter effect is estimated to have contributed to the decline in the order of approximately 1 / 3 percentage point in long - term government yields in the us in 2005 ( imf, 2006 ). this point is especially important in light of the fact that some research has explained the dampening economic impact of earlier oil price shocks by the endogenous reaction of monetary policy ( bernanke, gertler and watson, 1997 ; barsky and kilian, 2004 ). inflation is driven by expectations about future inflation, current and expected future demand and supply factors ( both translated into the summary statistic of the output gap ) and cost - push shocks. unlike demand shocks, which affect inflation and economic growth alike – that is, either both positively or both negatively – cost - push shocks are more of a challenge. a surge in oil prices will raise inflation ( at least in the short term ) while dampening economic growth, thereby constituting a trade - off if monetary policy tries to achieve price stability without compromising real economic developments in general. the trade - off between inflation and output stabilisation in the face of macroeconomic shocks is also influenced by real rigidities. real wage rigidities, especially, are important in this context. 5 from the aforementioned, it is clear that the possible trade - off for monetary policy is influenced by various transmission channels over and above the cost - push element alone. firstly, the better inflation expectations are anchored, the less a cost - push shock leads to higher future inflation. secondly, an oil price shock influences not only output but also potential output. the concrete relative factors are difficult to gauge for policy makers in real time. notwithstanding this identification issue, it is clear that the popular notion of equating the observable dampening effect of higher oil prices on gdp with a corresponding decline in the output gap may be seriously misleading. the problems are compounded by the fact that there is not the one all - encompassing concept to