we worry as much about inflation falling below the target as we do about it rising above the target. through most of the last decade, we have succeeded in keeping inflation close to the target. and so, canadians'expectations for inflation have become anchored around 2 per cent. all this has helped to smooth out the ups and downs in the economy and to create the best possible environment for longer - term economic growth. this framework may sound simple in theory. but it is quite complex in practice. our monetary policy decisions are based on economic projections, which can always be thrown off by unforeseen events. because monetary policy actions take time to have their full impact on the economy, we must aim these actions at where we see the economy sitting 18 to 24 months into the future. in doing so, we are always looking at what is called the output gap - the difference between the actual level of production in the economy and the level of potential output. if the economy is operating above its potential capacity and inflation appears likely to be above target in the future, then we would tighten monetary policy. this would cool demand and bring inflation back down to the target. on the other hand, if the economy is operating below its potential capacity and inflation appears likely to be below target in the future, we would ease monetary policy in order to stimulate demand, close the output gap, and bring inflation back to its target. this means that we are always looking at demand and supply in the economy and trying to bring them into balance. so, in carrying out our policy, a large part of the analysis we do is concerned with the many factors that can influence demand and supply. the most important factor is, of course, the strength of domestic demand. but canada is a trading nation, and so the strength of world demand is also important to us. in particular, the united states is a major customer for canadian goods, so we closely monitor the health of the u. s. economy. economic activity is also affected by movements in exchange rates. as you well know, there has recently been a significant adjustment in the value of the u. s. dollar against major currencies, including the canadian dollar. as always, we need to understand the causes of this movement, as well as its effect on the canadian economy. furthermore, movements in exchange rates have a direct effect on the prices of traded goods and services and, therefore, on inflation. however, our research has shown that, in economies such as canada

effects of monetary easing - - that is, although low interest rates are conducive to improving corporate profits, it seems that businesses are simply using those earnings to repay their debts, and therefore, the desired effects of stimulating economic activity, such as increasing investment, have not been achieved. some even say that the low interest rates are only delaying the structural adjustment of the japanese economy. if we take a look at the actual figures of corporate profits and business fixed investment, cash flow of firms - - hat is, retained earnings plus depreciation - - increased by approximately ¥7 trillion in the two years since fiscal 1995, when the official discount rate was lowered to 0. 5 percent. business fixed investment also increased by approximately ¥7 trillion, commensurate with the growth in corporate profits. during this two - year period, the low interest rates have helped to improve the profitability of investment and to support corporate profits. therefore, the bank believes that low interest rates have had the effect of generating an appropriate increase in business fixed investment. it should be noted, however, that in past phases of economic recovery, firms borrowed from financial institutions to expand their business fixed investment in addition to using their cash flow. this time, however, few firms have increased bank lending or issued bonds for this purpose. rather, in quite a few cases, firms have used the increase in profits to repay their debt. thus, there has been no significant acceleration of business fixed investment when compared to past recovery phases. one factor behind this seems to be the various structural adjustment pressures that the japanese economy faces today, notably persistent balance - sheet adjustment pressures. as you are aware, many firms borrowed actively from financial institutions during the economic “ bubble ” period to engage in large - scale real - estate investment or securities investment. following the bursting of the economic “ bubble ”, prices of real estate and stocks plunged. the borrowings, however, remained. thus, on corporate balance sheets, there was a significant depreciation of assets at market value while liabilities remained unchanged. this resulted in a decrease in the net worth of firms - - that is, assets less liabilities - - and this in turn has limited the business risks that these firms can take on. firms in this situation can rarely conduct active investment in plant and equipment that leads to the expansion of their business activity. this situation is often referred to as the “ balance - sheet problem ”. when we look at the relationship between balance sheets and business fixed investment