If it appears that inflation will be lower than 2½ per cent with unchanged interest rates, the interest rate will be reduced. There is symmetry here. It is equally important to avoid an inflation rate that is too low, or deflation, as it is to avoid an inflation rate that is too high. When the annual use of petroleum revenues is managed according to a long-term action plan, a policy for which there is currently fairly general political consensus, we should normally be able to use the interest rate as a policy instrument to prevent high inflation. Normally, monetary policy should also be a fairly effective means of countering a deflationary recession. Stagflation, ie stagnating output and rising unemployment combined with rapid inflation, which characterised economic developments in many countries in the 1970s and 1980s, originates in the supply and output side of the economy or in income determination. If the Norwegian economy should ever be threatened by stagflation tendencies, monetary policy must be directed towards maintaining low and stable inflation. At the same time, structural policy and incomes policy should contribute to improving the functioning of the economy, allowing economic growth and employment to pick up. A change in interest rates is not expected to have an immediate effect on inflation. Our analyses indicate that a substantial share of the effects of an interest rate change occurs within two years. Two years is thus a reasonable time horizon for achieving the inflation target of 2½ per cent.

The capacity of policymakers to restore stability was constrained by the depth of the balance sheet problems. In some cases, where the scale of external borrowing was less acute, policymakers had more room to act. But in most cases, policy options were very limited. Initially, governments were reluctant to let exchange rates move too far, because of fears that this would force banks and companies that had borrowed in dollars or yen into default on a scale that could further damage growth. At the same time, the authorities were reluctant to tighten monetary policy as a way to help stabilize the exchange rate because of concern it would hurt growth and perhaps exacerbate the flight from domestic assets. This dilemma made the initial policy response in the crisis countries look halting and tentative. And, uncertainty about the strength and continuity of political leadership further hampered government efforts to recover credibility. In the countries hit hardest by the crisis, looming issues of succession and elections compounded the problem of confidence. The crises prompted a searching reassessment of the conventional economic wisdom and a new appreciation of the challenges that come with financial integration. The classic measures of macroeconomic stability and policy prudence, in fiscal positions and measured inflation rates, could mask substantial structural weaknesses, and these same structural weaknesses could ultimately undermine the achievements of otherwise reasonably conservative macroeconomic policy management. Partial capital account liberalization, which encouraged the accumulation of short-term debt obligations, brought substantial risk, magnifying weaknesses in domestic financial systems.