the policy interest rate. 8. monetary policy has embraced the taylor rule so firmly that there has been an intense debate in the wake of the crisis on the policy stance of the us fed vis - a - vis the taylor rule. some analysts used the taylor rule to argue that the fed funds rate, even at this historically low level, was not low enough and made out a case for doing a lot more to stimulate the economy. prof. taylor himself weighed in on the issue suggesting that those analysts were not applying his rule correctly. he contended that, quite to the contrary, his measure shows just the opposite : that the fed policy is appropriate, the policy rate cannot remain low for too long, that central bankers are right to be considering withdrawal of their unprecedented monetary stimulus, and that critics who say otherwise are misinterpreting his rule. according to him, the formula is designed to show the best rate for spurring growth without stoking inflation. 9. if the taylor rule is so time tested in prescribing the policy interest rate, it is legitimate to ask what role there is left for central bankers. i do not have a simple answer for this ; perhaps prof. taylor does. i do have a complex and somewhat longish answer and here it is. 10. for my long and complex answer, it is necessary to refer to the interesting debate on whether economics can be a deterministic and exact science like physics. indeed, some people argue that one of the great follies of economics – the reason it often lost direction, if also credibility is because it had pretense to being like physics. i have no intention of getting into that debate, but in the context of the taylor rule, i can ’ t resist the temptation of drawing upon a comparison of economics with physics, if at an altogether different level. 11. sir isaac newton gave us the three laws of motion and the law of gravity. the mathematical formulation of these laws embodies a complete description of the universe. all you need to specify are the initial conditions and using newton ’ s laws, you can calculate the state of the universe for eternity with absolute determinism. this is classical cartesian reductionist framework in its quintessence. people, therefore, asked, if god has decided on the laws and decided on the initial conditions, he has determined the course of the universe for eternity. besides, he gave us newton to let us know of the laws so that we

s attempt to influence the exchange rate as an interesting opportunity to make a profit. events in autumn 1992, at the start of 1997 and autumn 1998 show that exchange market interventions cannot stem the pressure on the krone. norges bank does not want to intervene in such a way that these game situations arise. however, the bank may use interventions to a limited extent if the krone exchange rate moves substantially out of line with what we consider to be reasonable based on fundamentals or in the event of exceptional short - term volatility in thin markets. in such situations, there is less risk of ending up in a game situation against exchange market operators. we have also experienced game situations in which one or more major operators were behind the krone exchange rate fluctuations and at the same time took speculative positions in the capital market in the expectation that norges bank would raise its key interest rate to defend the krone. if we focus too narrowly on the exchange rate when setting interest rates, we are liable to end up in game situations. speculators have little to gain from such game situations if norges bank proceeds gradually and avoids abrupt shifts in the setting of interest rates. in practice, the interest rate is the only monetary policy instrument available to norges bank. the interest rate can influence the exchange rate directly through the differential between domestic and foreign interest rates, and indirectly through inflation expectations. higher interest rates normally make krone positions more attractive. an increase in the interest rate will therefore result in an appreciation of the krone, and a lower interest rate will weaken the krone. however, this relationship presupposes that the market is confident that monetary policy provides the economy with a nominal anchor. in some situations, interest rate changes may have the opposite effect. a higher interest rate can weaken the krone if it contributes to a deflationary recession, and a lower interest rate can strengthen the krone if it contributes to preventing a deflationary recession. the interest rate only has a predictable effect on the krone exchange rate when it influences price inflation in the right direction. 2 historically, it has often been the case that the central bank has raised its key rate when confidence in monetary policy has declined, and the currency has been exposed to depreciation pressure. this is probably one of the reasons why it has proved difficult to find empirical support for a direct relationship between the interest rate and the exchange rate. the impact of the interest rate on the krone exchange rate will depend on how