the target necessary, the degree of transparency, etc. it has also been important to formulate a monetary policy reaction function, that is, to define the balance between inflation variability and output variability. the reason why central banks do not aim for maximum short - term stability in either inflation or output is that attaining only one of the targets would be costly. on the one hand, the central bank ’ s legitimacy among the general public could be lost if short - term interest rates have to move sharply and cause output to fluctuate widely while inflation is being held stable and exactly on the target. maximum stability in output could, on the other hand, result in sharp fluctuations in the rate of inflation and erode the target ’ s credibility. instead it is a matter of finding a point somewhere midway between the two extremes. looking ahead, i believe there are at least two major questions that central banks have to address more thoroughly. first, how should monetary policy react to asset prices, such as equity and / or real estate prices? we know from history that the development of asset prices can have a significant impact on both inflation and real economic activity. we need to establish whether or not there are actions that central banks can and should take to minimise the likelihood of macroeconomic instability arising from extreme fluctuations in asset prices. second, how should monetary policy react to structural changes in the economy? on this issue quite a lot of thinking has already been done, both among academics and policymakers. nevertheless, i believe that more must be done in this field, especially since at least some parts of the world economy have seen something of a productivity shock in recent years. i am carefully trying to avoid using the buzzword “ new economy ” here, since history has been full of expressions like that ever since the turn of the 19th century. unfortunately, i do not have the time to elaborate on the first question. instead i will say a few words about the second. although the discussion about monetary policy and a productivity shock is taking place mostly in the united states, in the light of the impressive economic performance there and the acceleration in the rate of productivity growth, one could certainly ask : what about europe? europe is, on the one hand, now in a strong upward economic phase. in addition, new technology, especially the internet and telecommunications, is gaining ground in many european countries. on the other hand, europe also differs from the us. the rapid growth of us investment has not yet been seen in europe. one

could also argue that the existence of quite a few structural obstacles in europe makes an acceleration of productivity growth less likely in the immediate future. a handful of countries - including the netherlands, ireland, the uk and, more recently, sweden and finland - have achieved strong economic growth and in some cases also low inflation. but with the exception of ireland, these countries have not yet enjoyed the same strong productivity growth as the us. nevertheless, the possibility of a productivity breakthrough also in europe cannot be ruled out. it will probably depend on how well europe succeeds in reforming microeconomic policy. higher - or accelerating - productivity growth does indeed pose new challenges for monetary policy. it could set in motion a complex of effects on aggregate supply and demand, on inflation, equity prices and interest rates. just to give a few examples, let me briefly mention the following effects : first, a positive productivity shock raises the economy ’ s potential growth rate. it also affects aggregate demand through new, profitable investment opportunities, higher equity prices and expectations among households of higher permanent income. one question for policymakers is whether the demand effects are so powerful that they have the potential to outpace the growth of aggregate supply in the short and medium perspective. second, there could be temporary disinflation effects at work if the increase in productivity is unexpected initially. if wages are slow to adjust, higher productivity growth lowers unit labour costs and thereby reduces price inflation. here again there are important questions for policymakers. should this effect be allowed to result in a temporary reduction of price inflation or unemployment? third, an increase in the trend rate of productivity growth could also result in a higher equilibrium real interest rate, when the output gap is closed, in order to balance saving and investment. fiscal policy and the development of public financial balances could at least partly offset this effect, as could the economy ’ s degree of openness. all this implies that monetary policymakers, also in europe, could face quite a few challenges. one of them is to identify structural changes and distinguish these from cyclical variations. another challenge is to detect the magnitude of the effects. furthermore, looking ahead in monetary policy is hard when the economy is going through major changes that make it difficult to forecast the future path of the economy and inflation. it is quite clear that this demands a great deal of forecasters as well as of those who construct macro models. the forecasts concern inflation one to two years ahead, which calls, for instance, for reasonable precision in the