For reasons unrelated to the domestic situation, but reflecting a prolonged period of low inflation in the euro area, the ECB is using both conventional and unconventional measures to stimulate aggregate demand. Hence interest rates are extremely low: consider that the domestic 10-year bond yield is now below 1%. Such low rates stimulate aggregate demand. One could also argue that, in the absence of the ECB’s monetary policy measures, the euro would also be much stronger than it is today. This would have had adverse implications for external competitiveness and, hence, Maltese exports. Over the last two years, the economy also benefited from exceptionally strong government investment - with a key role played by EU funds - as the administration made sure that available entitlements were absorbed to the fullest extent possible. This capital spending has both a temporary and a permanent effect. While the projects themselves are under way, investment boosts aggregate demand as seen in the levels of activity in the construction sector. Once the projects are completed, the additional capital stock that has been put in place enhances efficiency and allows the economy to continue growing into the future. This brings me to a crucial concept in the analysis of Malta’s underlying economic performance: potential output. Potential output can be understood in many ways. Intuitively  Page 3 of 8  it can be seen as the maximum output an economy can produce without generating imbalances that show up in inflation. Potential output is a conceptual measure.

The form that these flows take in many countries, short-term and foreign-currency based, further contributes to the building up of financial mismatches with potentially severe financial and macroeconomic consequences. Moreover, even before a  BIS central bankers’ speeches  3  crisis occurs, capital surges have macroeconomic impacts through the expansions in activity resulting from credit growth, the factor reallocations that may be associated with persistent exchange rate movements, and the inflationary or deflationary pressures that may arise from the combination of exchange rate pass-through and aggregate demand expansions. In cases where capital flows are not excessive and driven by fundamentals, the pursuit of macro and financial stability can be consistent with the inflation targeting framework and exchange rate flexibility, even though it may be accompanied by moderate exchange rate volatility and real exchange rate appreciation. Under these conditions, exchange rate flexibility helps the efficient reallocation of resources and thus becomes the first line of defense in avoiding the building up of risks. For example, the delayed appreciation of exchange rates to improved domestic conditions could be a factor that accelerates capital inflows to take advantage of artificially low asset prices. Therefore, a flexible macroeconomic framework geared to avoiding the buildup of overheating and that allows prompt asset price adjustment should be the main way to avoid excessive, especially speculative, capital inflows. But even if flows are not “excessive”, agents may undertake exposures that could be privately efficient, such as currency and maturity mismatches, but result in aggregate vulnerabilities.