without putting undue pressure on monetary conditions. we were formally asked if the tax cuts could proceed without creating such upward pressure on monetary conditions, and after careful consideration we formally advised government that we believed the tax cuts would not create any undue upward pressure on monetary conditions. as reserve bank watchers may – 11 – recall, this was close to the time when we reached the judgement, in october 1995, that inflationary pressures were abating and that some easing in monetary conditions might be appropriate. we in the bank, others in the treasury, and many private sector forecasters all felt that the economy would slow down markedly in 1996, and that the proposed fiscal stimulus would not create undue pressure on monetary conditions. in retrospect, our judgement was incorrect : inflationary pressures in the economy had not eased by as much as we thought at the time and, as it turned out, a firm monetary policy had to be maintained for a further year. and of course, by the time we thought that the outlook was sufficiently subdued that monetary restraint could be eased without inflation becoming a problem, the asian crisis was about to break. this course of events serves to underscore just how difficult it is to fine tune monetary policy, and why i am reluctant to claim that swings in the exchange rate are a thing of the past. there may also be difficult political obstacles in using fiscal policy to carry some of the load otherwise carried by monetary policy. in late 1995, the new zealand public sector was in very substantial operating surplus and, in the absence of tax cuts or increases in government spending, that surplus looked likely to continue indefinitely. even leaving aside the fact that both the reserve bank and other forecasters mis - read what was likely to happen to the economy in 1996, it could well have been difficult to persuade any parliament in those circumstances to forego tax cuts or increases in government spending. in the end we got both, and part of the price may well have been a continuation of strong exchange rate appreciation for longer than anybody in the export sector enjoyed. thirdly, measures might be taken to drive a wedge between new zealand interest rates and foreign interest rates, so that when monetary policy is tightened in new zealand to head off inflationary pressures this does not result in an appreciation of the exchange rate, or at least results in a rather smaller appreciation than otherwise. various countries try to do this. some, for example, have tried to cut themselves off from international capital markets by instituting comprehensive controls on

##nz calculation ) and of course ‘ leaning hard against inflationary pressures ’ is a euphemism for pushing up real ( inflation - adjusted ) short - term interest rates. in 1992, our real short - term interest rates were actually lower than the oecd average ; in 1993, they were very close to the average ; but from 1994 until some six months ago they were well above the oecd average. ( see figure 3. ) figure 3 short - term real interest rates : new zealand and selected oecd countries ( sources : rbnz, international financial statistics, rbnz calculation ) – 4 – while various factors help to explain why the new zealand dollar appreciated from early 1993 to early 1997, our research suggests that the dominant explanation is the obvious one, namely the relative strength of the domestic economy and the resulting inflation pressures. those inflationary pressures necessitated significant monetary restraint, as reflected in the rise in new zealand ’ s short - term interest rates relative to those in our trading partners. higher interest rates in new zealand than elsewhere ensured plenty of demand for new zealand dollar assets, which is another way of saying that there was upward pressure on the exchange rate. in other words, the strong appreciation of the mid - nineties was the direct result of demand growing to the point where inflationary pressures would have pushed up measured inflation markedly had it not been for firm monetary policy. it was not until the domestic inflation pressures had clearly dissipated that the twi began to depreciate, around may 1997. secondly, was the appreciation in some sense abnormal or unusual? it is helpful in answering this question to look not at the movement in the nominal exchange rate but at the movement in the real ( inflation - adjusted ) exchange rate. figure 4 shows the real exchange rate measured on a trade - weighted basis. what the graph shows is that the real exchange rate rose between early 1993 and april 1997 by 29 per cent, compared with an increase of 36 per cent between late 1984 and mid 1988. so the most recent appreciation was slightly smaller than the one experienced in the mid - to late eighties. figure 4 new zealand trade - weighted real exchange rate ( source : rbnz ) another important point can be seen in the graph, and that is that, although some exporters are particularly prone to measuring exchange rate appreciations from the very bottom of an exchange rate cycle, it is as unrealistic to imply that the bottom of the cycle is in some way the norm as it would be to