##ze the economy. … and by a higher dependency ratio due to population ageing. the third challenge is the demographic shift caused by population ageing, such that the ratio of the working age to the dependent population is expected to shrink from almost four - to just over two - toone by the late 2020s. some effects of this trend are already being felt this year as the first cohorts of the baby - boom generation reach retirement age. this has produced a significant acceleration, by some lm7 million or 10 per cent of the budget deficit, in the rate of increase in pension expenditures. pension reform clearly cannot be delayed any longer. population ageing also represents a broader threat to the sustainability of living standards and to social cohesion because the burden of supporting a growing number of dependent persons will, at some point, become unbearable for the productive sectors of the economy. this burden consists not only of pension and other welfare payments, but also of services provided in kind, most notably by the public health system. this is another reason why reducing government recurrent commitments should be a priority objective. a better understanding of the magnitude of these challenges can be obtained by synthesising their effects in terms of the growth rate necessary for the economy to deal with them effectively. for example, in order just to compensate for the increase in the dependency ratio associated with population ageing, the economy would have to grow by around 1 per cent per annum over the next twenty years. at this rate of growth, which is more or less what malta averaged over the past five years, there would not be any improvement in per capita gdp, that is in living standards. as for hopes of raising the activity rate by ten percentage points to around 70 per cent over twenty years, the economy would have to grow by an average annual rate of at least 3 per cent. this growth rate, in turn, would still not be sufficient to ensure convergence with the average per capita gdp of the eu twenty years from now. for this latter objective to be achieved, a real growth rate of some 4 per cent would be required. the way forward : a concerted push for faster growth these scenarios underline the urgency of achieving more rapid, sustainable growth. the longer it takes to expand the productive base of the economy, the more onerous the challenge will be. the prospects for a significant recovery in the short term, moreover, are doubtful since oil prices are expected to remain at their current high level, and the dynamic benefits of fiscal

central banks were based on keynesian theory, with the demand side of the economy driving growth. however, the inflationary experience of the late 1960s showed the importance of modelling the supply side, which led to the successor model, rdx2. but after the oil price shock of 1973 – 74, the bank wanted to use its model to examine alternative policies. the bank actually began targeting the money supply as a means of reducing inflation and anchoring inflation expectations in 1975, but rdx2 did not have the ability to compare alternative policy paths. this led to the development of rdxf, with “ f ” denoting “ forecasting. ” this version of rdx2 was more amenable to policy analysis. acquisition of an in - house mainframe computer greatly facilitated this work. this is the model that was being used for quarterly projections when i arrived at the bank in 1981. i can vividly recall my initial disappointment with rdxf. i was fresh out of graduate school, where the natural rate hypothesis and rational expectations were de rigueur. the natural rate hypothesis holds that there is no permanent trade - off between inflation and unemployment. rather, the economy settles at full employment in the long run, and inflation reflects the impact of monetary policy actions and people ’ s rational expectations. rational expectations were seen as key to anchoring both models and economies as well as critical for properly analyzing alternative policy paths. the gaps between rdxf and the thinking of the day became even more real when the bank dropped its monetary targets and began searching for a replacement policy anchor. we believed that rdxf would be vulnerable to the lucas critique. the lucas critique held that empirical models based on data generated under a given policy regime and expectations - formation process would prove unstable and forecast poorly when the policy regime shifted. by the late 1980s, the bank was converging on targeting inflation directly as the central goal of monetary policy. this meant policy making would put much more focus on the future. we needed a model that would allow the bank to make detailed projections — not just over the next couple of quarters, but for at least two years into the future — to reflect the lag between interest rate changes and their ultimate effect on inflation. 2 / 7 bis central bankers'speeches this thinking led to the development of sam, the small annual model. sam incorporated the natural rate hypothesis and also defined a steady state to which the model would converge after being hit with a shock. however, the flip