eva srejber : the transmission mechanism speech by ms eva srejber, second deputy governor of the sveriges riksbank, at umea university, umea, 15 may 2001. * * * the riksbank has a statutory duty to maintain price stability. however, it has the power to decide how to operationalise monetary policy and the monetary policy strategy that is to guide the monetary policy decisions. in the annual assessments of the performance of the riksbank made by the riksdag finance committee, both the objective and the strategy adopted have won acceptance. monetary policy is governed by an inflation target expressed as the annual rate measured by cpi is to be limited to 2 per cent with a tolerance interval of ± 1 percentage point. however, the decision to define price stability as a reduction in the value of the krona by two per cent per year in relation to the basket of goods and services consumed by swedish households is by no means self - evident. in principle, another rate of price increases, other weighted combinations of goods and services, financial assets or currencies could serve as the anchor in relation to which the value of the krona is to be kept stable. when the inflation target was adopted in 1993, conditions did not favour a return to any form of fixed exchange rate. the decision that had to be made then was how best to design monetary policy to cope with the transition from a high to a low - inflation economy while, at the same time, creating suitable conditions for returning to a fixed exchange rate regime. cpi was deemed to be the best known measure of inflation and this was one reason why it was very suitable in a situation where confidence in stable prices was to be attained. an inflation rate of two per cent was considered to be well in line with inflation in the rest of the eu and this was adopted to create a basis for stabilising the nominal exchange rate of the krona in relation to the european currencies. by monetary policy strategy i mean the entire framework used to comply with the ultimate objective that monetary policy is intended to achieve. besides operationalising the target, this concerns, for instance, how the system is to be designed to enable the central bank to influence interest rates and how open and clear monetary policy is to be. it is also about taking decisions on any intermediate objectives and the time horizon in which fulfilment of the objective is to take place. the decision on monetary policy strategy fundamentally rests on conceptions of how

and property prices which in turn affect consumption decisions. the interest rate channel therefore affects demand for goods and services and thus the output gap with some time lag through many complicated mechanisms. changes in the use of resources or the output gap then affect inflation in turn, with some time lag. the impact of changes in the instrumental rate on demand and inflation may also be affected by the lending rate set by the banks. the channel that is mediated by the behaviour of the banks can be generally referred to as the credit channel. higher interest rates may, for instance, reduce the willingness of the general public to keep funds deposited in current accounts, which have a very low return. deposits have a very low financing cost for the banks and if they have to finance an increased proportion of their lending in another way, the banks may compensate for this by a higher lending rate. however, it is uncertain how the behaviour of the banks affects the impact of monetary policy. changes in the instrumental rate have an effect through the " exchange rate channel " partly by changes in the nominal exchange rate for the krona affecting the relative prices for net export. higher interest rates should thereby strengthen the domestic currency and make domestic goods more expensive relative to other goods and vice versa. higher interest rates thereby dampen export at the same time as import becomes cheaper and increases. lower demand for domestic goods contributes to reducing the use of resources and subduing inflation. a stronger nominal exchange rate dampens consumer prices at the same time since part of consumption is directed towards imports when prices are dampened. however, lower import prices also increase the real purchasing power which per se contributes to increasing purchasing power. in economies with diversified industry an increase in the interest rate thus also leads via the exchange rate channel to lower inflation. the strength of the effect depends inter alia on income and price elasticities and on the composition and size of foreign trade. in certain cases the positive effect on incomes from stronger currency can even predominate and vice versa. changes in the nominal exchange rate probably have less impact on import and export prices if the changes are not considered to be lasting. in a floating exchange rate regime, it is therefore probable that changes in the nominal exchange rate will not have such a great effect as in the case of a devaluation or revaluation in a fixed exchange rate regime. the role of inflation expectations the channels i have now pointed out operate in most cases through demand and the output gap. one channel that is probably very important and