shortage of labour and other economic resources, a tight monetary policy stance will reduce inflation by affecting aggregate demand. conversely, when unemployment is high, low interest rates will stimulate demand and contribute to stable wages and prices. a monetary policy stance that is aimed at stabilising inflation will thus also contribute to stabilising aggregate output and employment. the time it takes for a change in interest rates to affect demand and inflation will vary. our analyses indicate that an interest rate increase of 1 percentage point over two years reduced mainland gdp by ¾ - 1 percentage point after two years. the effect is thereafter reversed. the inflation rate is reduced by an estimated 0. 20 - 0. 35 percentage point after two years and 0. 30 - 0. 40 percentage point after three years. we have taken into account that an interest rate change will affect the krone exchange rate. it is assumed that monetary policy credibility remains intact. developments in the krone exchange rate have a considerable impact on inflation in a small economy such as norway. our analyses, which are based on relationships in the norwegian economy over the past 20 - 30 years, indicate that it takes some time for the effects of a lasting change in the exchange rate to pass through to consumer price inflation. the effect seems to be strongest the second year and then shows a gradual decline. a sustained appreciation of the effective krone exchange rate of 5 % could reduce the rise in consumer prices by a quarter percentage point the first year, by close to half a percentage point the second year and about a quarter percentage point the third year. our analyses indicate that a sustained increase in wage growth of 1 percentage point will, in isolation, push up consumer price inflation by a quarter percentage point the first year and half a percentage point the second year. the mandate implies that the interest rate must be adapted to the outlook for the norwegian economy. if it appears that inflation will be higher than 2½ % with unchanged interest rates, the interest rate will be increased. if it appears that inflation will be lower than 2½ % with unchanged interest rates, the interest rate will be reduced. this orientation of monetary policy will normally also contribute to stabilising output and employment. the impact of monetary policy occurs with long and variable lags. our analyses indicate that a substantial share of the effects occurs within two years. a time horizon of two years when setting interest rates allows monetary policy to contribute to stabilising production. this horizon prevents monetary policy in itself from causing unnecessary fluctuations in the economy.

the sharp rise in labour costs in recent years carries with it a potential for higher unemployment. the interest rate is an effective instrument for countering lower demand and growing unemployment when measures to stimulate demand do not translate into higher wage growth or unstable financial markets. however, there is little monetary policy can do to prevent an increase in unemployment that is driven by high cost inflation. a pre - condition for an effective interplay between wage settlements and monetary policy is that the response pattern in monetary policy is known and consistent. when the response pattern in monetary policy is known and consistent over time, the social partners can take into account monetary policy responses when negotiating wages. in 2002, wage growth was higher than we had expected up to the wage settlement in the spring of 2002. in spite of the rise in unemployment, the wage settlement in 2002 indicated that the social partners still perceived the labour market as tight. preliminary figures indicate annual wage growth between 5½ og 6 % in 2002, which is substantially higher than projected. the high level of wage see box in inflation report 2000 / 4 : effects of an interest rate change. see box in inflation report 2002 / 2 : how does the krone exchange rate influence the cpi. growth fuelled expectations of continued high interest rates in norway relative to other countries and appears to have contributed to the appreciation of the krone. the unexpected high level of wage growth required a tight monetary stance. norges bank increased its key rate last summer. the interest rate differential against trading partners widened and the krone appreciated. this appreciation also reflected other factors, such as uncertainty in stock markets and higher demand for nok - denominated assets, which were perceived as a safe investment in an otherwise turbulent period. in the long run, wages must be commensurate with the value added that is generated by workers. real wage growth is thus determined over time by developments in labour productivity in all sectors of the economy. if historical productivity growth trends persist, the long - term rate of growth in labour costs that is compatible with the inflation target is 4½ %. the outcome of the wage settlements we have observed in recent years is not consistent with this. if monetary policy is to have an impact, it is important that wage growth responds to labour market tightness. since the mid - 1980s, wage growth has been markedly higher in norway than among trading partners. earlier, the krone was devalued in response to high wage growth, which contributed to veiling the effect of relatively high