consequences for the domestic economy. a macro - prudential overlay will usually be applied on a temporary basis, for example during an upward asset price cycle, and be applied to all banks. the main aim of such policies is to help bolster the balance sheets of the banks so they can better withstand the impact of a potential credit or liquidity shock and continue to extend credit in support of economic activity. macro - prudential policies can also help to reduce the strength of the financial cycle by slowing credit growth, e. g. by restricting the amount of credit being extended to the booming sector. we will always be subject to economic and financial cycles. that is the historical reality. however, we can and should avoid the severe financial cycles that can cause major damage to the real economy – as we have seen internationally in the aftermath of the gfc. our aim therefore is to reduce the amplifying effects seen in severe financial contractions by ensuring we have a very resilient banking system and also by directly moderating the credit cycle itself. our on - going prudential requirements, together with macro - prudential overlays, aim to achieve that. there is a point to clarify here around the stress testing that the reserve bank conducts on the banking system as part of our prudential oversight function. sometimes commentators bis central bankers ’ speeches incorrectly interpret the aim of macro - prudential policy as preventing bank insolvency. from a macro - prudential perspective, we may wish to bolster bank balance sheets beyond the point of avoiding insolvency. stress tests help to inform our assessment of the adequacy of capital and liquidity buffers held by the banks. however, they are only one of the tools contributing to that assessment. in a downturn, banks will typically become risk averse and start to slow credit expansion in order to reduce the risk of breaching capital and liquidity ratios. in a severe downturn, faced with a rise in impaired loans and provisions, banks may start to contract credit which can quickly exacerbate the economic downturn. in this way, a financial downturn can have severe consequences for macro - financial stability well before the solvency of banks becomes threatened. in 2014, the four largest new zealand banks completed a stress testing exercise that featured a 40 percent decline in house prices in conjunction with a severe recession and rising unemployment. while this test suggested that banks would maintain capital ratios above minimum requirements,

have only a temporary effect is a drought, which in the short term typically pushes up the prices of agricultural products like fruit and vegetables, generating inflation. however, increases in the prices of things like fresh fruit and vegetables generally would not be seen by the public as the start of a general inflation problem. so it is unlikely that the inflationary consequences of this sort of disturbance would be long lasting. that is particularly true because overall spending in the economy would be reduced by a drought, because farm incomes would be down. so if monetary policy is excessively focused on price stability and we attempt to stop inflation caused by temporary climatic shocks, we could end up exacerbating a recession. by contrast, a policy which looks through short - term inflation fluctuations is much less disruptive to the real economy, and, of course, that ’ s what we do. in addition, the challenges that central banks face change over time. look at other developed countries over the past decade or so. having successfully eliminated the inflation problems of the 1970s and 1980s, central banks could be forgiven for expecting the late 1990s and this decade to be an easy ride. in reality, many central banks face arguably greater challenges. for example, in japan, despite interest rates falling to very near zero, weakness in private sector demand has persisted for the best part of a decade. monetary policy in japan has been unable to prevent deflation - that is, persistent falls in the overall level of prices. in the united states, the challenge has been running monetary policy in a period where many people believed the economy was moving through a technological revolution that would lead to a prolonged inflation - free, economic boom. that belief translated into very high asset prices, which helped to underpin a long period of strong consumption and investment spending. a key question policy makers faced was whether the asset prices represented fair value, or were a bubble that reflected a collective over - optimism about the future. finally, many central banks, including new zealand, have struggled with the consequences of volatile nominal exchange rates. for example, both the norwegian and british currencies have persisted at high levels which have been very tough for their exporters. there has been little scope for monetary policy in those countries to solve this problem without generating inflation that would be equally damaging to their exporters. in my view new zealand is not about to undergo any of these scenarios. but the world that we face now has moved on from the world of 1989, when the reserve bank act was passed