Norges Bank has explained its interpretation of the Exchange Rate Regulation on several occasions, not least in a letter to the Ministry of Finance dated 21 October 1999, often referred to as the budget submission. When exercising discretion, Norges Bank attaches importance to fulfilling the fundamental preconditions for exchange rate stability. To ensure stability in the exchange rate against the euro, monetary policy instruments must be oriented towards reducing price and cost inflation to the level aimed at by the European Central Bank. At the same time, monetary policy must not in itself contribute to deflationary recessions, as this could undermine confidence in the krone. Hence, there is no conflict between gearing monetary policy instruments towards low and stable inflation and the objective of a stable krone exchange rate over time. In the budget submission, the Bank also provided information about key policy response patterns when price and cost developments and the basis for exchange rate stability are influenced by external factors. Price and cost inflation are influenced by monetary policy through a number of channels. When interest rates increase, it becomes more profitable to save and to postpone consumption until a later date. Interest expenses exceed interest income for households collectively, meaning that a rise in interest rates reduces real disposable income. The value of household wealth decreases, since interest rate rises normally lead to lower house prices and weaker trends in securities markets. Growth in private consumption and fixed investment slows. Lower demand for goods and services may also affect enterprises’ profit margins.

In its December 1999 Inflation Report, Norges Bank presented calculations based on our macroeconomic model which illustrated that an interest rate rise of 1 percentage point might reduce price inflation by 0.3 percentage point after two years. This reduction is largely due to the effect on the exchange rate. These calculations were based on the assumption of uncovered interest rate parity. An interest rate rise will then result in an immediate appreciation of the krone, which is sufficient for the interest rate differential between Norway and other countries to correspond to expectations of future changes in the exchange rate. After three years the effect is somewhat less strong as a result of the depreciation of the krone, but at this stage domestic factors will gain in importance. A number of comparative analyses have been published which study the effect of rises in interest rates on inflation in different industrial countries.1 There is substantial variation in the calculations across countries and between different analyses. In a report published by the Monetary Policy Committee of the Bank of England,2 the effect of an interest rate rise which is sustained for one year is illustrated using simulations in the bank’s macroeconomic model. After two years, inflation has fallen somewhere in the region of 0.2 to 0.4 percentage point, dependent on the other assumptions. The report emphasises that the effects are dependent on factors such as the general state of the economy and the credibility of the monetary policy regime.