Consumer price inflation in Norway declined sharply, however, through 2003 and into 2004. It is important to understand the background for these developments. The most appropriate - or optimal - monetary policy response will depend on underlying shocks or disturbances. A number of factors seem to have contributed to pushing down inflation to such a low level. The appreciation of the krone through 2002 contributed to a sharp fall in prices for imported consumer goods. A shift in trade patterns and the cyclical downturn in the world economy may also have contributed. Since mid-2003, however, a more subdued rise in prices for domestically produced goods and services was primarily responsible for reducing overall price inflation. In our Inflation Report, we have pointed out that intensified competition in retail trade and other service sectors in recent years may have contributed. In the first round, increased competition affects companies’ profit margins because prices are pushed down. Many companies have probably responded by rationalising operations in order to cut costs. Although there is probably no model that would a priori have captured the considerable disturbances to which the Norwegian economy has been exposed, it is useful to be able to analyse the effects of the disturbances after they have occurred. Therefore, let us use the model to look at the qualitative effects of a fairly long-lasting increase in competition in product markets. The magnitude and duration of the shock has been adjusted so that inflation in the model illustration falls by around 1 percentage point.

In the charts, all the variables are shown as deviations from a baseline scenario, i.e. a path for  6  BIS Review 4/2005  economic developments without such a disturbance. The figures on the X-axis indicate the number of quarters. Increased competition reduces companies’ possibilities for setting prices higher than marginal production costs. This contributes to a reduction in prices. Owing to nominal rigidities, however, it takes time for prices to adapt to increased competition. Therefore, inflation falls gradually. The interest rate is reduced to counter the fall in inflation and to bring inflation back to the target. Lower real interest rates combined with lower price inflation contribute to higher consumer demand. Output increases to meet higher demand. Higher output increases demand for factor inputs such as labour and capital. Therefore, the number of man-hours increases. Investment also rises as a result of lower real interest rates. Increased demand for labour results in a tighter labour market and upward pressure on nominal wages. Lower price inflation has the opposite effect. Therefore, nominal wages may remain relatively stable, while real wages increase sharply. Thus, real marginal costs increase. This will gradually contribute to pushing up price inflation. The prospect of higher inflation leads to a gradual increase in the interest rate. An increase in real interest rates curbs demand. Since increased competition is assumed to be only temporary in this illustration, there will be no permanent effects on output. Therefore, the economy will gradually return to the baseline scenario.