##ages promote economic growth in the world through two key mechanisms : the division of labor and the international spillovers of knowledge. in this context, the current recovery in the japanese economy is taking place in tandem with the growing interdependence with the rest of the world, particularly with the other east asian economies. the direct investment of japanese businesses to east asian economies accelerates the reallocation of their production bases. consequently, between japan and the other east asian countries, both exports and imports are growing substantially. exchange rate movements have the short run and long run influence on an economy. as for the short run effects, exchange rate movements influence the economy through changing relative prices between goods at home and abroad. recent empirical studies, however, show such short run effects become small because the exchange rate pass - through to import prices declines. on the contrary, exchange rate movements still play an important role in facilitating more efficient resource allocations in the long run. at the previous conference, professor maurice obstfeld here mentioned in his keynote speech that exchange rates still have significant expenditure - switching effects through influencing firms ’ decisions on production bases and production - goods suppliers across borders. in fact, the recent increase in intra - firm trading enables businesses to shift their activities across borders smoothly, thereby strengthening the response of economic activity to exchange rate movements in the long run. asset price fluctuations and financial systems asset price fluctuations have important implications for promoting more efficient resource allocations and achieving sustained growth in the long run. the staff at the institute will present an analysis on how asset price fluctuations and subsequent structural adjustments influence sustained economic growth, based on japan ’ s experience since the second half of the 1980s. they emphasize the viewpoint that the protracted economic stagnation in japan derives from incomplete economic adjustments to significant changes in relative prices. in view of the incomplete economic adjustments during the post bubble distress, we fully realize that the malfunction of financial intermediation impedes the resource allocation mechanism in the financial markets. with weak balance sheets, banks tend to continue lending unprofitable businesses and leave them existing. such lending policy hampers the factor reallocation to more profitable businesses. good news is that banks ’ lending attitude seems to be gradually becoming far more accommodative than in the previous recoveries. this shows that major banks in japan have made good progress in solving non - performing loan problems. the resultant improvement in bank balance sheets is expected to enhance their loan capacity. well - functioning financial systems are

contrast with the picture painted by the various business surveys, which is considerably stronger, and for the moment take the figures as given. that leaves growth running more slowly than was anticipated earlier in the year. but if output growth fell slightly short of expectations, it was not due to apparent lack of demand. growth in domestic final demand has run at something like 5 per cent over the past year, and an average rate of nearly 6 per 3 / 7 cent per year over the past three years. and growth in global demand for things australia produces has, over the past year or two, been generally as strong as at any time in the past few decades. graph 3 click to view larger if demand growth is so strong, why hasn ’ t the economy grown faster? have we hit capacity limits? indicators of capacity utilisation available in business surveys are certainly at or close to the highest levels seen in the past 15 years. this is a feature across surveys, and has been for some time. in the labour market, the rate of unemployment is at its lowest for more than 25 years. other measures of under - utilisation of labour are not at two - decade lows, but have nonetheless declined a good deal. a significant proportion of firms refer to difficulties in finding suitable staff. areas of skill shortage have emerged. observable upward pressure on wage and salary rates is minor at this stage, though there are reports of non - wage employment costs rising in some sectors. the clearest evidence of hard capacity constraints is probably on the export side. in some parts of the resource sector there was a significant volume of investment in the second half of the 1990s, but a subsequent period of weak commodity prices saw investment decline to very low levels. hence, the increase in demand in the past two years apparently left some producers without the capacity to take full advantage of the conditions by shipping higher output, though of course they have enjoyed higher prices. the rise in prices presumably reflects pressure on capacity globally, which suggests that producers everywhere were surprised. there have also been reports of capacity constraints in some of the key areas of transport infrastructure, such as ports and rail. a decline in exports of some fuels was due to a rundown in reserves, a capacity constraint of another sort. at the margin, the weakness of manufactured exports might reflect the strength of domestic demand, which for some producers may have presented an opportunity for sales in an easier market than some foreign alternatives. it might reflect the rise in the exchange rate (