end of june this year. under the oil fund mechanism, increased government petroleum revenues are invested abroad. this curbs the impact of oil price fluctuations on domestic demand and output - and on inflation and the krone exchange rate. a floating krone exchange rate also has a stabilising effect, and the exchange rate normally appreciates in favourable periods and depreciates during adverse periods. a flexible exchange rate can reduce fluctuations in employment and output. in march 2001, the fiscal rule and new guidelines for monetary policy were introduced. the fiscal rule implies that the central government budget deficit shall be equivalent over time to the expected real return on the fund, quantified as 4 per cent. the operational target of monetary policy as defined by the government is inflation of close to 2. 5 per cent over time. this establishes a clear distribution of responsibilities among the different components of economic policy. monetary policy steers inflation in the medium and long term and can also contribute to smoothing swings in output and employment. the inflation target provides economic agents with an anchor for their decisions concerning saving, investment, budgets and wages. fiscal policy – growth in public expenditure – influences the krone and the size of the internationally exposed business sector in the medium term. government expenditure and revenues must be in balance in the long term. wage formation, the structure of the economy and incentives determine how well and how efficiently we utilise our labour resources and other economic resources. the transition to inflation targeting in 2001 may have appeared at that time, and in norway, to be a transition to a new and unfamiliar monetary policy system. but today ’ s monetary policy system springs from an historical recognition of what monetary policy can in fact achieve. in collaboration with the norwegian school of economics and business administration, norges bank has compiled price data from the mid - 1600s onwards. history shows that price stability is the norm. high inflation is a phenomenon associated with monetary disturbances in times of war and need, and a 1970s and 1980s phenomenon associated with an unsound macroeconomic policy and undermining of the nominal anchor. in many countries, including norway, the perception in the 1960s and 1970s was that strong growth and low unemployment could be achieved if only we were willing to accept somewhat higher inflation. but experience showed that this was not an option. counter - cyclical policy through the 1970s in norway and a number of other countries contributed to rising inflation. inflation expectations were gradually revised upwards and inflation took hold at a high level. in both economic

therefore be forward - looking in interest - rate setting. in the operational conduct of monetary policy in norway, the path of inflation and the real economy in the period ahead will be taken into account. see akram, farooq q ( 2003 ) : “ reell likevektsvalutakurs for norge ” ( real equilibrium exchange rate for norway ), in norsk økonomisk tidsskrift, 118, pp 89 - 112. normally, the interest rate is set with a view to achieving inflation of 2½ per cent at the two - year horizon. this time horizon usually provides a reasonable balance between stabilising inflation on the one hand and smoothing fluctuations in output and employment on the other. if extraordinary conditions prompt norges bank to apply a different time horizon than two years, the bank will provide an assessment of this. the same applies if special emphasis is placed on developments in financial markets. there is one main monetary policy instrument : the interest rate. the interest rate is set with a view to achieving low and stable inflation, while at the same time seeking to avoid substantial variations in output and employment. in the long run, output is determined by the supply of labour, capital and technology and by the ability to adapt, but in the short and medium term monetary policy can also have an impact on the real economy. flexible exchange rates in a small, open economy, the exchange rate is an important channel for monetary policy. the krone fluctuates. this is not surprising because other countries ’ currencies also fluctuate. the krone exchange rate is the price of our currency measured in a foreign currency. developments in other countries are just as important for the krone as developments in the norwegian economy. capital flows freely and flows can change rapidly. this can spill over to exchange rates and interest rates as well as output and employment. the chart shows the effective exchange rate for norway and a number of other small countries with inflation targeting. exchange rate fluctuations are approximately the same for norway, sweden and canada, whereas the krone exchange rate fluctuates less than the exchange rate for australia and new zealand. therefore, the krone does not stand out as particularly unstable compared with other countries ’ currencies. the forward exchange and options markets have expanded in recent years. a deeper market reduces transaction costs and it is easier to find counterparties. this has provided companies with greater scope for hedging against foreign exchange risk. instruments that