on the then prevailing economic and inflation situation. therefore, it would be premature to discuss the specifics of an exit at this stage. bis central bankers ’ speeches concluding remarks urgent need for strengthening growth potential finally, let me talk about the medium - to long - term challenges facing japan ’ s economy. i pointed out that one of the factors behind the rise in the year - on - year rate of change in the cpi is that the output gap has been narrowing and recently has reached around 0 percent, that is, the long - term average. this is mainly due to the increase in demand accompanying the moderate economic recovery. but from a somewhat longer - term perspective, it is also due to a decline in supply capacity in the economy. in fact, japan ’ s potential growth rate has been on a downtrend since the 1990s ( chart 13 ). the potential growth rate is determined by the growth in labor input, capital input, and improvements in productivity through innovation and the like. let me review the trends in these three sources of growth – labor input, capital input, and productivity – that underlie the downtrend in the potential growth rate. first, labor input has been substantially affected by demographic changes. while demographic changes due to aging can be seen in many advanced economies, such changes have been much more pronounced in japan than elsewhere ( chart 14 ). these demographic changes have been one factor putting downward pressure on the potential growth rate through the decline in labor supply. second, capital accumulation has slowed because japanese firms were weighed down by the need to resolve the problem of excess capital stock during the process of adjusting their balance sheets following the burst of the bubble. in addition, protracted deflation reduced firms ’ investment appetite and resulted in the deferral of business fixed investment. third, productivity growth has also declined. one reason is that while concentrating on dealing with the aftermath of the bubble, japanese firms were unable to adapt fully to major changes in the global economy such as advances in information and communication technology and intensified global competition. in addition, in the aforementioned deflationary equilibrium, innovation by firms was stifled and productivity growth thus subdued for a protracted period. against this backdrop, for japan ’ s economy to grow on a sustained basis, it is critical to address all three sources of growth. while it has been recognized for quite some time that strengthening the growth potential is a key challenge facing japan ’ s economy, it was not seen as an urgent issue when demand was weak. in that

##ncies, that between the us dollar and the chinese renminbi, should be abandoned. for the past decade, the chinese currency has been pegged by the people ’ s bank of china at a rate of around 8. 28 renminbi per dollar. critics of this policy, mainly leading us politicians and some industrialists, believe that chinese exports have been given an unfair advantage when the renminbi has tracked the dollar ’ s fall against the euro. the most drastic answer to these exchange rate issues would be to propose a new global monetary system of the kind that existed after the second world war and up to the early 1970s in the shape of the bretton woods agreement and the link via the dollar to gold. this kind of solution has actually been recommended by robert mundell, a currency area theorist and winner of the 1999 nobel prize in economic sciences. even keynes considered the establishment of a global currency, the bancor. mundell points to transaction gains for trade and the financial markets, but also other arguments. one of these is that the signalling of international relative prices is distorted by exchange rate fluctuations caused by capital flows. another is that the global economy has led to increasingly weak money illusion, the illusion that prevents wage - earners from immediately perceiving a deterioration in their purchasing power following a depreciation, and from demanding compensation that would render the depreciation ineffectual. despite the intellectual appeal of such arguments, it is not difficult to see that during the past decade, the us, europe and japan have had very different growth rates and their business cycles have been highly unsynchronised. given that monetary policy would be dictated by the monetary system, a tremendous burden would be placed on fiscal policy to stabilise the economy when the differences across the common monetary area are too great. the large real adjustments that would be required in wages and relative prices in the us and europe - instead of an adjustment in the exchange rate - would probably cost more than the gains derived from having fixed global exchange rates. therefore, the requirements necessary to make such a system work, which in reality are the factors that determine what constitutes an optimal currency area, indicate that such a solution is a distant prospect, if it should become reality at all. in addition, there are the practical and administrative problems of organising such a global monetary system, indeed even a global central bank with representation from all countries. a middle ground between a single currency or single monetary standard such as bretton