the accelerator, over the next few months. but will we need to step on the brakes, and if so, how hard? the answer, as so often in economic matters, is “ it depends ”. our statement projects some need for monetary policy to become restrictive, to apply the brakes, over the next year or two. but at this stage this seems likely to involve a rather milder tightening in monetary conditions than has been the case historically. one of the reasons for this belief is that new zealanders now carry a lot more debt, relative to their incomes, than they did a decade ago. we are assuming a relatively moderate rate of growth in household sector expenditure in the next few years as a result. in particular, we are assuming that the rate at which new debt is taken on will slow down as compared with the nineties, and that increases in interest rates will have a bigger impact on consumption expenditure and even on new house - building than in the nineties. of course, we could be wrong on this assumption, in either direction. there is not much evidence yet that increased debt levels have encouraged a slow - down in the rate at which consumption is growing, so it is possible that demand arising from the household sector will be stronger than we now project, requiring firmer monetary conditions than we now project. conversely, debt levels may be such that even small increases in interest rates induce a slow - down in consumption spending and in house - building, requiring monetary conditions to be rather easier than now projected. another important area of uncertainty is the exchange rate. at the present time, the new zealand dollar is close to its lowest level ever, on a trade - weighted basis. there are many reasons for this. new zealand short - term interest rates have been lower than those in several other english - speaking countries, providing little inducement to foreigners to invest in new zealand dollar assets. the commodity prices of greatest relevance to new zealand seem to be recovering rather more slowly than do some other commodity prices. there has been some nervousness about the political environment, among investors both here and abroad. new zealand has a large current account deficit, which looks likely to improve only slowly. to the extent that the exchange rate is weak because of low commodity prices, we know that offsetting the stimulus of the low exchange rate is the disinflationary effect of weak export prices. this would suggest no need for monetary policy to react. on the other hand, to the extent that exchange rate weakness

is unsustainable. over time inflation expectations and nominal wages adjust to monetary expansion such that long - run unemployment and output are largely unchanged, but the rate of inflation is higher. indeed, it can be counterproductive to use monetary policy to target higher inflation in pursuit of better output growth over the longer - term. such attempts risk unanchoring inflation expectations resulting in higher and more variable inflation. high and variable inflation can harm long term growth. 4 high and variable inflation generates considerable uncertainty for individuals and businesses, hindering their willingness and ability to plan and contract over the long term. businesses have differing abilities to change their prices in response to inflationary shocks. as some businesses change prices and others do not, it becomes difficult to distinguish a generalised increase in prices from a shift in relative prices when the inflation rate itself is variable. unexpected inflation acts as a hidden tax on financial investment for savers, yet reduces the real interest burden of debt for borrowers. this can distort saving and investment incentives and increase the inflation - risk premium embedded in interest rates. eventually a reaction sets in against high inflation. past experiences suggest that reducing inflation materially usually involves a greater slowing in activity than the boost to growth acemoglu, johnson and robinson ( 2004 ). see, for example, barro ( 1995 ), bruno and easterly ( 1998 ), oecd ( 2003 ). bis central bankers ’ speeches enjoyed as inflation increased. there is evidence to suggest that for advanced economies, the threshold at which inflation becomes negative for long term growth may be as low as 3 percent. 5 the gains from operating monetary policy to achieve low and stable inflation are difficult to observe and may appear small. gains from macroprudential policy in moderating credit cycles may be similarly difficult to observe. but, poor policy in either case can cause material damage to long term growth prospects as unsustainable booms unwind. conclusion there is a range of factors that can cause potential output to fluctuate over the short, medium and long terms. potential output is determined by the economy ’ s productive base – that is the supply of labour and capital and the efficiency with which these factors are utilised. the quantity and quality of these productive inputs are largely determined by the preferences and choices made by individuals and businesses – how much to work, how much to save, and how much to invest. these preferences can be influenced – for good or for ill – by the policies of