in one step. instead, it moved higher over time as commodity prices increased. another aspect of the uncertainty is the extent to which the higher commodity prices influence the three different flows i ’ ve just described. this will depend in turn on a number of things, including : • how much extra export revenue is earned by existing resource operations and how much of that accrues to australian residents ; • the extent of new investment in the resources sector ; • how much of the investment expenditure is accounted for by australian workers and companies helping to put the physical capital in place ; and • how much additional export revenue is generated by the new production facilities and how much of that accrues to australian residents? bis central bankers ’ speeches using history as a guide these are very difficult things to know in advance. we could try to estimate the three types of flows directly – perhaps with reference to past behaviour – and then update these estimates as we observe the flows over time and the evolution of the economy more generally. that, in essence, is what foreign exchange markets do one way or another. alternatively, we could start the process by estimating a model linking the exchange rate to some of its key determinants. this is not meant to imply that past behaviour provides an “ optimal ” benchmark, but it can be a useful guide nonetheless. one approach is to run a regression of the real exchange rate against the terms of trade and a measure of the ( real ) interest differential ( between australia and those of large countries with open capital markets ). it turns out that this relatively simple “ reduced - form ” model produces reasonable statistical results over a long period, which doesn ’ t mean that it is very accurate, just that there are no obvious contenders that are better. graph 4 compares the actual real trade - weighted index of the australian dollar ( the real twi ) with estimates of the medium - term “ equilibrium ” exchange rate from the model i just described. this is the level that the exchange rate has tended to settle at over time for given levels of the terms of trade and the interest rate differential. 9 we can see that the exchange rate has, on occasions, deviated noticeably and for some time from the “ equilibrium ” estimates. 10 the shaded band around the “ equilibrium ” gives a sense of the standard deviation of the actual exchange rate from the model estimates. however, even this range suggests more precision than may be warranted, since the level of the “ equilibrium ” can vary quite a bit depending

seeking in australia in recent years. that this is necessary is confirmed by the fact that inflation has picked up somewhat. cpi inflation in 2003 was 2. 4 per cent. in 2004 it was 2. 6 per cent, and in 2005 2. 8 per cent. in mid 2006 it was nearly 4 per cent. to be sure, the consumer price index was affected by the rise in oil prices, and most spectacularly, the effects of cyclone larry on the queensland banana crop during march of last year. but the rise in prices was more widespread than just those items. measures of underlying inflation, less influenced by specific price shocks, suggested a pick - up, albeit a much more modest one, from about 2½ per cent to about 3 per cent by mid 2006. a short - lived pick - up of that magnitude is not necessarily a major problem in itself. but in an economy with limited spare capacity, continuing signs of quite solid growth in demand, and experiencing a substantial external stimulus, that gradual trend rise in underlying inflation was worrisome. a continuation of this trend could have seen inflation exceeding the 2 – 3 per cent target over a more sustained period, even after temporary factors had disappeared. it was this risk – not banana prices or petrol prices per se – to which monetary policy had to respond. it was intended that the rise in interest rates, by restraining the growth of demand, would allow the supply side of the economy some time to catch up, and so act to contain inflationary pressures over time. how, then, do we evaluate the current situation and outlook? most indicators suggest the economy expanded at a moderate pace through the second half of 2006. while housing construction remained a bit below average, engineering and non - residential building have been very strong. consumer demand picked up a little pace, and at present it is being assisted further by the decline in petrol prices. at the same time, the very serious drought has strengthened its grip on the rural sector, and farm production and incomes will be sharply lower this financial year as a result. the demand for labour has remained very strong, with higher than average increases in employment and some further decline in the rate of unemployment through the turn of the year. data on job vacancies and from business surveys suggest little moderation in this area in the near term. looking abroad, the world economy continues to post a strong performance, led by the us and china. many commentators have for some time pointed to the possibility of a sharper -