extent to which they are changes in the path of potential output. the reserve bank expresses growth in potential output as the sum of contributions from estimates of trend growth in capital inputs, labour inputs, and productivity. estimating potential output in real time is challenging. growth in potential output is not constant – its path does not in reality follow a straight line as shown in our stylised figure. views on the level or growth in potential output, both at present and over history, can and do change. views can differ from analyst to analyst or model to model, even based on the same data. the reserve bank ’ s assessment of potential output has changed the reserve bank has recently revised its estimates of potential output growth. the bank expects growth in potential output in new zealand to increase over the forecast horizon as labour and capital resources available in the economy increase. annual growth in potential output is estimated to peak at around 2. 8 percent in 2015. this demonstrates a marked improvement in growth prospects from an estimated trough in potential growth of 1. 2 percent following the 2008 / 09 recession. bis central bankers ’ speeches figure 4 : components of potential output growth source : rbnz estimates. our estimate of potential growth has increased since december, from a peak of 2. 5 percent in 2015 to 2. 8 percent. the increase in our estimate of potential growth is because : • data revisions now reveal that there has been more investment in productive capital than previously thought ; • strong business confidence suggests that future investment could be stronger than previously thought ; and • the supply of labour is expected to be stronger than previously anticipated, due in part to increased net immigration. growth in actual output is expected to have peaked at around 4 percent in the year to june, driven by strong construction spending, increasing net immigration, high export prices, and low interest rates. with the economy growing at a faster rate than potential output, inflationary pressures are expected to increase. in this environment, it is important that inflation expectations remain contained and that interest rates return to a more neutral level. structural changes and the economic cycle cause potential growth to fluctuate growth in potential output fluctuates over the medium term as the availability of factors of production is influenced by the state of the economy. let me explain this further using the example of one of the labour supply components of potential output – the labour force participation rate. labour force participation captures the share of the total working age population ( i. e. the population aged over 15 ) that are working

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