rate. developments in international financial markets provided fertile ground for more pronounced fluctuations. and more fundamentally, when labour market pressures rose and incomes policy failed, exchange rate developments were no longer providing signals for wage formation and fiscal policy. high petroleum revenues, fiscal slippage and expectations of increased use of petroleum revenues contributed to this. therefore, the exchange rate was no longer suitable as a nominal anchor. the introduction of new guidelines for economic policy in march 2001 and the conduct of fiscal policy have altered the interplay between economic policy components. in the past, growth in public spending was to be reduced or other fiscal policy measures implemented if the labour market was tight and wage growth high. with today's guidelines, it is primarily monetary policy that is tightened in a similar situation. the rise in labour costs is important when norges bank assesses the outlook for price inflation and sets interest rates. excessive wage growth, in both manufacturing and other industries, will affect the internationally exposed sector through two channels. first, high wage growth will in itself reduce earnings and employment. second, the interest rate will be increased. normally, this will lead to an appreciation of the krone, with a further reduction in earnings and employment. the manufacturing sector will therefore feel the effects of excessive wage growth to an even greater extent than earlier. since the new fiscal guidelines, which entail an increased use of petroleum revenues, were introduced during a period with a tight labour market, it was to be expected that the krone would be strong at times. at the same time, it is important to be aware that low wage growth will be of double benefit to the exposed business sector. with wage growth as low as in the mid - 1990s, partly as a result of incomes policy, and other things being equal, the interest rate would probably have to be set in such a way that the krone fell in value in order to bring price inflation up to 2. 5 per cent. how does monetary policy function? monetary policy affects the economy through a number of channels. let us make a stylised review of what happens if the central bank raises the key interest rate. in the short and medium term, this will result in a rise in the real interest rate. normally, the exchange rate will also be strengthened. prices for imported goods are an important part of the consumer price index ( cpi ). an appreciation of the krone reduces prices for imported goods measured in nok. this is often called the “ direct exchange rate channel to inflation

svein gjedrem : the economic outlook and monetary policy speech by mr svein gjedrem, governor of norges bank ( central bank of norway ), for norges bank ’ s regional network, oslo, 9 november 2006. the text below may differ slightly from the actual presentation. the address is based on the assessments presented at norges bank ’ s press conference following the executive board ’ s monetary policy meeting on 1 november and inflation report 3 / 06. the charts in pdf - format can be found on the norges bank ’ s website. * * * the economic situation the world economy is currently experiencing its strongest continuous upturn since the early 1970s. this has contributed to solid growth in the norwegian economy. norway ’ s terms of trade have improved by nearly 30 % since 2000, and activity in the export industry is very high. globalisation has resulted in a low rise in prices for imported consumer goods at the same time as strong growth in demand for commodities and semi - finished goods has led to high prices for many norwegian export goods. the terms of trade for traditional goods and services have also improved, albeit to a lesser degree than for overall trade. so far in the cyclical upturn, the mainland economy has grown by an average of close to 4 per cent annually. current information about economic developments indicates that the cyclical upturn is continuing. corporate sector profitability is solid. companies are borrowing and investing. there is strong growth in employment, unemployment has fallen markedly, and household demand continues to rise. capacity utilisation in the business sector is high and a growing number of enterprises are now facing constraints. statistics norway ’ s business tendency survey for the third quarter shows that norwegian manufacturing is optimistic about the prospects ahead. a clear majority of industrial leaders assess the general outlook as more positive in the short - term than in the third quarter. a majority of industrial leaders are considering an increase in investment. a shortage of skilled labour is posing a mounting challenge to manufacturing in the period ahead. this picture is consistent with information from the company contacts in norges bank ’ s regional network. in the august round of interviews, 59 per cent of the companies reported capacity problems, and this share has increased since the previous round. output and employment are increasing in all sectors. pressures are particularly strong in the building and construction sector and some corporate services. the rise in prices is moderate in retail trade. it also appears that extensive use of foreign contract labour, particularly in some manufacturing sectors