bank sets the interest rate with a view to achieving inflation of 2½ per cent at the two - year horizon. there are two reasons for this : • changes in the interest rate affect inflation with a lag. • a reasonable balance is usually achieved between stabilising inflation on the one hand and smoothing fluctuations in output and employment on the other. a rapid and pronounced change in the interest rate may be appropriate in cases where there is a risk that inflation may deviate considerably from the target over a longer period, or where heightening turbulence in financial markets or a cost - push shock resulting from wage negotiations indicates that confidence in monetary policy is in jeopardy. financial market confidence in the inflation target provides norges bank with greater scope for promoting stability in output and employment through monetary policy. this scope will also increase as the inflation target is incorporated as an anchor for wage formation. we have also indicated that in the event of runaway overall credit growth and a sharp rise in property and house prices as well as equity prices, it may be necessary to reassess the time horizon. it would in general have been possible to achieve the inflation target at a horizon shorter than two years by changing the interest rate more rapidly and more markedly. this might, however, have a greater impact on output and employment. norges bank has based its monetary policy on flexible inflation targeting, where variability in output, employment and inflation are given weight. how do changes in the interest rate affect the economy? norges bank ’ s monetary policy instrument is the key rate. norges bank ’ s key rate affects short - term money market rates, and expectations concerning future developments in the key rate are decisive for banks ’ deposit and lending rates and bond yields. it may be useful to distinguish between three channels through which monetary policy operates : • the demand channel • the exchange rate channel • the expectations channel the effect on inflation of changes in interest rates occurs with a lag and may vary in intensity. in the time it takes for a change in interest rates to feed through, other factors will also have an impact resulting in changes in inflation and output. we cannot assume that the various relationships are entirely stable. as interest rates fall, household and municipal consumption and investment will tend to accelerate. this is because they have more money left over after servicing their debt and because borrowing is less expensive. corporate finances are strengthened and investment may become more attractive. higher demand leads to higher output and employment. wage growth may pick up. higher wage growth combined with

svein gjedrem : the conduct of monetary policy introductory statement by mr svein gjedrem, governor of norges bank ( central bank of norway ), at a hearing before the standing committee on finance and economic affairs of the storting ( norwegian parliament ), oslo, 1 december 2003. please note that the text below may differ slightly from the actual presentation. the statement is partly based on the assessments presented in “ report on monetary policy in 2003 - the first eight months ” and norges bank ’ s inflation report 3 / 2003. the charts in pdf can be found on the norges bank ’ s website. * * * i would like to thank the storting for inviting norges bank to appear for the first time before this committee to report and answer questions on monetary policy in connection with the storting ’ s deliberations on the government ’ s credit report. the mandate the operational target of monetary policy as defined by the government is inflation of close to 2½ per cent over time. the target is symmetrical - it is equally important to avoid an inflation rate that is too low, as it is to avoid an inflation rate that is too high. the inflation target provides an anchor for economic agents ’ expectations concerning future inflation. it provides an important basis for choices concerning saving, investment, budgets and wages. households, businesses, public entities, employees and employers can base decisions on the assumption that inflation in norway will be 2½ per cent over time. we have a very open economy with free capital movements. the krone exchange rate fluctuates from day to day. we do not have the instruments to fine - tune the krone exchange rate. stable inflation expectations may nonetheless contribute to stabilising the exchange rate. stability in the exchange rate and in exchange rate expectations over time are dependent on stable inflation expectations, which in turn depend on low and stable inflation. norges bank sets the interest rate so that future inflation will be equal to the inflation target of 2½ per cent. high demand for goods and services and labour shortages normally point to higher inflation. an increase in interest rates curbs demand and keeps inflation at bay. when demand is low and unemployment rises, inflation will tend to slow. interest rates will then be reduced. the inflation target is therefore a vehicle for, not an obstacle to, monetary policy ’ s contribution to stabilising output and employment. this objective is also expressed in the regulation on monetary policy. normally, norges