karolina ekholm : monetary policy and the exchange rate speech by ms karolina ekholm, deputy governor of the sveriges riksbank, at a meeting, stockolm, 12 january 2010. * * * i intend to begin today by talking about the background to the monetary policy decision made by the executive board of the riksbank on 15 december last year and how i viewed the economic situation. the main part of my speech will focus on the riksbank ’ s assessment of the krona exchange rate. i intend to discuss the role played by the exchange rate in a small, open economy like sweden ’ s, and the difficulties in forecasting the exchange rate. the current situation and the monetary policy decision as you probably know, the executive board decided at our meeting on 15 december to hold both the repo rate and the forecast for the repo rate unchanged in relation to the previous monetary policy meeting in october. i shall not go into details regarding the forecasts on which our decision was based, but i will focus on some specific questions that have been important for the stance i took. the world economy has improved recently, and this benefits developments in the swedish economy. our most recent assessment contains an upward revision to the forecasts for gdp and employment, both in sweden and abroad. however, i see a number of risks relating to international developments in the period ahead. emerging markets in asia and latin america are now showing fairly good growth, while growth in the industrial nations in europe and north america remains low. the fact that different parts of the world economy are developing fairly differently creates problems that have significance for monetary policy. the low short - term interest rates and good access to liquidity in europe and north america make it attractive to borrow in the short term to invest in assets with a high expected yield. there have been reports of large capital inflows to several of the emerging markets. these inflows tend to push up asset prices – for instance, house prices and share prices – in several asian countries. at the same time, the experiences gained from the financial crisis over the past year and during the asian crisis of the 1990s indicate that these flows can change direction abruptly, which creates a risk of substantial falls in asset prices in the future. it is difficult to say what the consequences of the capital flows we are now seeing will be for the development of the world economy in the period ahead, but there is a risk that imbalances will be generated.

the theory of relative purchasing power parity thus appears to apply. 23 if the real exchange rate does not have any trend, it will return to its average in the long run. there are thus results in the academic research indicating that real exchange rates fulfil relative purchasing power parity in the very long run. 24 however, these results have little value for those trying to forecast exchange rate developments in the short and medium term. as i mentioned earlier, it is moreover the trade - weighted krona exchange rate that the riksbank tries to forecast. figure 5 showed only the development of the krona against the dollar. if we return to figure 4, we can see that the real trade - weighted krona rate shows interestingly, there is research indicating that price differences for a big mac between countries even out over time in accordance with relative purchasing power parity. see, for example, cumby ( 1996 ) and parsley and wei ( 2007 ). see, for example, froot and rogoff ( 1995 ) and rogoff ( 1996 ) for a scientific survey of the research into purchasing power parity. see, for example, taylor large variations over fairly long periods. 25 the krona is much weaker in real terms at the end of the period than at the beginning of the period. what is the reason for this? it is largely due to developments in sweden ’ s real economy in relation to other countries. the riksbank ’ s forecasts for the exchange rate are based on changes in the real exchange rate reflecting differences in growth in relation to other countries and being consistent with foreign trade, being balanced in the long run. relative growth and the current account explain changes in the real exchange rate countries that have a higher gdp growth than their trading partners usually have a stronger real exchange rate. 26 the real trade - weighted krona rate has been on average 30 per cent weaker during the period since 1993 than it was in the 1970s. figure 6 shows sweden ’ s gdp in relation to tcw - weighted gdp abroad. we can see that swedish gdp in relation to other countries fell heavily from the 1970s until the beginning of the 1990s. the riksbank ’ s assessment is that the weakened exchange rate from the 1970s to the 1990s is linked to lower growth in sweden than abroad. as we can see in figure 6, sweden has over the past 15 years recovered some of the relative gdp level and had higher growth than other countries. this tendency is expected to continue over