enable the inflation target to be described as follows : a change in the instrumental rate affects gdp which in turn has an effect on inflation. if gdp increases at a rate that makes full use of production resources, inflation is not changed although if demand is so high that production resources are under pressure, then inflation will increase. when resources are under pressure, it is said that there is a positive output gap and vice versa when there are free resources in the economy. when growth is balanced, it is said that gdp increases in accordance with its potential growth path. according to this simple model, the central bank is able to affect inflation through its ability to affect the output gap. the emphasis here is not on the effect of the interest rate changes on demand for money, for instance, to be able to make payments for investments and consumption, but directly on the effect that the interest rate has on the real demand. the channels that enable the steering interest rate to have an effect on the output gap can be categorised in different ways : the most important channel is probably the interest rate channel. a change in the steering interest rate directly affects the shortest market rate. the banks can normally finance a deficit and invest a surplus at that rate. the shortest market rate and market expectations on future changes in the instrumental rate therefore constitute the alternative cost of the banks'financing or the alternative the quantity theory :, m * = y + p - v shows a demand function for money in the logarithmic form of m / p = 1 ( y, i ) where m is the volume of money, y is the real gdp, i is the interest rate and v = y ( m / p ) is the rate of circulation, i. e. the velocity. return on the bank's loans and holdings of securities. the banks'lending rate and the interest rate on securities are therefore affected by the actual and expected instrumental rate. monetary policy thus also has a direct effect on the interest rates encountered by the general public. i. investment and consumption decisions are affected directly by the interest channel. the required return on investment is reduced at a lower interest rate at the same time as saving is less profitable. ii. interest rate changes also have an income effect through interest income and interest expenditure on existing assets and liabilities. iii. interest rate changes also affect share prices and real estate prices – lower interest rates increase demand for shares and properties and prices increase. an interest rate reduction also affects household wealth through higher share

irma rosenberg : the objective of monetary policy speech by ms irma rosenberg, deputy governor of the sveriges riksbank, at a meeting arranged by a – hman fondkommission, stockholm, 14 february 2006. * * * a discussion has recently taken place in the media on the objective of monetary policy. some have argued that we should have more objectives while others considered that we already work with too many objectives and that this has created a lack of clarity. in my opinion this discussion is a bit misleading. we have one objective : keeping inflation low and stable. however, in our efforts to achieve this objective, we have, like many other central banks, opted to be flexible to avoid exposing the economy to strain. our statutory objective is to maintain price stability. it has been left to the riksbank to decide on the detailed interpretation of this objective. we have defined it as meaning that inflation should be 2 per cent. however, monetary policy affects the economy with a time lag and is simply not precise enough to maintain inflation at a constant 2 per cent. the inflation target includes a tolerance interval of + / one percentage point to underline that temporary deviations are permitted, provided that these are not too large. for further clarity, we apply the principle that in the event of any deviation, inflation should normally be brought back to the target within a two - year period. when we set the interest rate, we must accordingly base our decision on an inflation forecast. in most cases, this two - year horizon provides us with the scope to return gradually to the target without having to apply monetary policy with such force as to create unnecessary fluctuations in the real economy. occasionally in the wake of a major disturbance, there may even be grounds to allow a period of more than two years to return to the target. in such cases, however, we should communicate this clearly. like most central banks with inflation targets, we apply what is usually referred to as a flexible inflation target policy. when we decided at the most recent monetary policy meeting to increase the repo rate, we once again had to take into account the continuing rapid increase in house prices and household debt. this was not because we have a target for household debt or house prices. however, it is important for us to monitor the trend in the housing market, bearing in mind both financial stability and price stability. as far as financial stability is concerned, there are no indications that house prices or household debt constitute a threat