This paper describes the changes that occurred in the conduct and instruments of monetary policy used by major central banks when the crisis hit; discusses the new tradeoffs and controversies engendered by those policy reactions; and speculates about additional likely future changes in monetary policy and institutions. Following a brief account of the evolution of monetary policymaking principles and institutions in the past, the paper deals with the controversial question of how and when to exit a period of large-scale monetary expansion. The paper documents the fact that, in spite of huge monetary injections and historically low interest rates, inflation in the US and in the Eurozone remained subdued, and reports that since the onset of the subprime crisis, there has been a dramatic deceleration in the growth of banking credit in the US. The paper also discusses the tradeoff between the lender-of-last-resort function of the central bank and moral hazard; the consequences of bailout uncertainty for central bank policy; and the particular problems faced by the ECB in the face of a major financial crisis.

This paper discusses the problems exposed by the global financial crisis in the areas of financial regulation and supervision and possible solutions. It describes and evaluates current proposals regarding the role of the central bank as a systemic regulator, the pros and the cons of locating financial supervision in the central bank, and the conflicts and synergies that such an arrangement entails. Once a crisis erupts, central bank liquidity injections constitute a first line of defense. But in the longer term these injections create a trade-off between price and financial stability, and may compromise central bank independence. Problems exposed by the crisis include the growth of a poorly regulated shadow financial system, shortermism in executive compensation packages and consequent adverse incentive effects, the too-big-to-fail problem, procyclicality in the behavior of financial institutions, conflicts of interest in the rating agencies industry and the trade-off between the scope of intermediation through securitization and transparency in the valuation of assets. The paper also discusses international dimensions including international cooperation in regulatory reform and the scope for limiting exchange rate variability. The conclusion points out inherent difficulties in distinguishing ex ante between a fundamentals based expansion and a “bubble.”

[A two equation model that explains the simultaneous determination of wage and price inflation and their interaction with inflationary expectations (of the adaptive type) and real variables is presented. A dynamic definition of the long run trade off between inflation and unemployment is introduced and applied to the model in order to find conditions under which the model is stable or, in economic terminology, has a long run trade off. The model is then applied to the U.S. economy during the period 1949-1970. It is found that for all speeds of adjustment in expectations between 0 and 1 there is a permanent trade off.]

Using a Bayesian framework, this paper considers a risk-neutral firm which has to pick an investment project out of many that are available. It is shown that, if the firm is allowed to collect information, it will usually devote some time to information gathering before choosing. The main result is that, when uncertainty increases, the firm finds it profitable to delay investment decisions even further in order to collect more information. Thus increased uncertainty decreases the current level of investment even under risk neutrality. Another implication is that increased uncertainties cause an increase in the demand for liquid assets.

Politicians face a trade-off between the policies that maximize their chances of reelection and their most preferred policies (or the policies most preferred by the constituency which they represent). This paper analyzes this trade-off in a dynamic electoral model in which the voters are not fully informed about the preferences of the incumbent. First, we show that the incumbent follows a policy which is intermediate between the other party's ideal policy and his own ideal policy. Second, we show that, often, the incumbent has an incentive to choose procedures which make it difficult for voters to pinpoint his preferences with absolute precision. Thus, politicians may prefer to be “ambiguous.”

Using a generalization of a rational, partial information framework presented fully in Cukierman and Wachtel (1979), it is shown that there is a positive relationship between the variance of relative price change and the variance of inflationary expectations across markets in the economy. This implication is then tested empirically using data on the variance of relative price change and on the variance of directly measured expectations. The empirical evidence supports the view that there is a positive relationship between the two variances and that more than one-third of this relationship is explainable in terms of the model presented.

This paper develops a micro-founded general equilibrium model of the financial system composed of ultimate borrowers, ultimate lenders and financial intermediaries. The model is used to investigate the impact of uncertainty about the likelihood of governmental bailouts on leverage, interest rates, the volume of defaults and the real economy. The distinction between risk and uncertainty is implemented by applying the multiple priors framework to beliefs about the probability of bailout. Results of the analysis include: (i) An unanticipated increase in bailout uncertainty raises interest rates, the volume of defaults in both the real and financial sectors and may lead to a total drying up of credit markets. (ii) Lower exante bailout uncertainty is conducive to higher leverage, which in turn raises moral hazard and makes the economy more vulnerable to expost increases in bailout uncertainty. (iii) Bailout uncertainty affects the likelihood of bubbles, the amplitude of booms and busts as well as the banking and the credit spreads. (iv) Higher bailout uncertainty is associated with higher returns’ variability in diversified portfolios and higher systemic risks, (v) Pre-crisis expansionary monetary policy reinforces those effects by inducing higher aggregate leverage levels. (vi) The larger the change in bailout uncertainty and the change in aversion to this uncertainty, the stronger the pre-crisis buildup and the deeper the ensuing crisis. A central policy implication of the analysis is that the vaguest is bailout policy prior to a crisis, the lower is the magnitude of investments destroyed or missed due to errors in evaluating bailout and other intervention policies. On the other hand, the clearer is bailout policy upon the eruption of a crisis, the smaller the contraction of credit and the destruction of investment activity.