svein gjedrem : monetary policy - the importance of credibility and confidence address by mr svein gjedrem, governor of the norges bank, at the annual national meeting of the association of economists, held in gausdal on 25 january 2001. * * * introduction the primary responsibility of monetary policy is to contribute to nominal stability. nominal stability creates a more favourable operating environment for economic activity, and the prices of goods and services will be better conveyors of information. consequently, changes in the distribution of income and wealth as a result of variable price inflation are avoided. nominal stability is important to developments in the real economy, and is the most valuable contribution monetary policy can make to economic growth. using this as a starting point, i would like to speak today of the importance of confidence and credibility with regard to monetary policy. i will also evaluate the monetary policy that has been conducted for the last couple of years in relation to the guidelines for monetary policy and our interpretation of them. expectations and confidence expectations regarding the future play a large part in all economic activities. enterprises make decisions on production volume, investments, hiring and prices on the basis of expectations concerning future demand, prices and costs. households make purchases on the basis of their expectations with regard to future income, wealth, prices and job security. chart 1 illustrates a possible relationship between households'assessment of prospects for the future and their consumption. trade unions base their wage negotiations on expectations regarding price inflation and developments in employment over the next few years. expectations play an important part in financial markets. equity prices and exchange rates may fluctuate widely as a result of changes in the expectations of market participants. because expectations are of such importance to economic planning and decisions, it is essential that there is confidence in the nominal anchor. this makes it possible to achieve nominal stability with smaller disturbances in the real economy and lower unemployment. although nominal stability is a prerequisite for sound developments in the real economy over time, conflicts may develop in the short term. such conflicts may occur if there are disturbances on the production or supply side of the economy which give rise to higher price and cost inflation that does not actually reflect increased pressures in the economy. examples of such disturbances are cost - push shocks resulting from negotiations, or weaker productivity growth. when disturbances of this type occur on the supply side of the economy, there may be a trade - off between fluctuations in nominal prices and wages and fluctuations in production and employment. a trade - off of this kind

thus seem as if we are placing more weight on the output gap in the beginning of the period than at the end of the period. this suggests that the reference path in inflation report 3 / 06 is not consistent with a discretionary policy, where you make the best out of the situation in each period. such a strategy would have involved a higher interest rate in order to provide a better balance between inflation and output towards the end of the projection period. rather, it seems that the reference path has elements of commitment. let us therefore assume that we follow the response pattern we have committed ourselves to earlier. in the literature, one such strategy is referred to as commitment under a timeless perspective. 5 it is possible to calculate, within the confines of our models, an optimal interest rate path based on such a strategy. see for example woodford, m. ( 1999 ) “ commentary : how should monetary policy be conducted in an era of price stability? ”, paper presented at the jackson hole conference, see http : / / www. columbia. edu / % 7emw2230 / jhole. pdf. in this example, we have been able to reconstruct ( approximately ) the reference path in inflation report 3 / 06 by minimising a loss function under commitment in a timeless perspective. to reconstruct the reference path, the weight on the output gap in the loss function, lambda, has been set at 0. 3. we also had to place a weight on changes in the interest rate in the loss function. this weight, which penalises large changes in the interest rate, can be defended based on considerations regarding robustness and financial stability. what is the outcome if we depart from our established response pattern? the chart illustrates what might happen if the central bank reoptimises today, but promise never to do so again. in the model, this will result in a marked rise in interest rates today. but such an approach has been criticised in the literature. if the central bank departs from its response pattern today, it is easy to believe that it will do the same in the future. it may therefore be difficult to gain credibility for such a policy. even if it may feel tempting, it is important to be aware of the costs associated with departing from an established response pattern. it will then be more demanding to influence private - sector expectations. frequent reoptimisations will in practice undermine the benefit of commitment and lead to a discretionary policy. the