svein gjedrem : monetary policy and the economic situation speech by mr svein gjedrem, governor of norges bank ( central bank of norway ), at the norwegian university of science and technology, trondheim, 2 september 2003. the text below may differ slightly from the actual presentation. the speech is based on the assessments presented at norges bank ’ s press conference following the executive board ’ s monetary policy meeting on 13 august and on previous speeches. the charts in pdf can be found on the norges bank ’ s website. * * * the operational target of monetary policy as defined by the government is inflation of close to 2. 5 per cent over time. the inflation target provides economic agents with an anchor for their decisions concerning saving, investment, budgets and wages. the inflation target is a vehicle for monetary policy ’ s contribution to stabilising output and employment. this intention is also expressed in the regulation on monetary policy. high demand for goods and services and labour shortages normally point to higher inflation. when interest rates are increased, demand falls and inflation is kept at bay. when demand is low and unemployment rises, inflation will tend to slow. interest rates will then be reduced. norges bank sets the interest rate so that future inflation will be equal to the inflation target of 2½ per cent. the interest rate has been reduced since december last year in response to the change in the inflation outlook. this was the result of weaker cyclical developments in the world economy and a sharp drop in interest rates internationally. in addition, the norwegian business sector has felt the effects of the high norwegian cost level. the weak prospects at home and abroad have in turn had an impact on the norwegian labour market and the outlook for wage growth and inflation in the years ahead. 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 per cent with unchanged interest rates, the interest rate will be increased. if it appears that inflation will be lower than 2½ per cent 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 a lag. the current inflation rate does not provide sufficient information to determine the level at which interest rates should be set now. our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. thus, two years is

whole and with regard to oil prices, is still highly uncertain. weak external developments have in particular had negative spillover effects on the norwegian economy through the appreciation of the krone, the fall in equity prices last year and lower demand for norwegian exports. the krone exchange rate is the price of our currency measured in terms of a foreign currency. developments in other countries are just as important for the krone as developments in the norwegian economy. the krone has been strong. as a result, prices for imported goods have fallen. this has contributed to low inflation despite strong wage growth over a period of several years. our analyses indicate that the most important reason for the appreciation of the krone from may 2000 to the end of 2002 was the positive and widening interest rate differential. combined with the interest rate differential, the fall in equity prices and reduced fluctuations, or volatility, in foreign exchange markets contributed to the appreciation of the krone last year. the effect of the interest rate differential on the krone has been amplified by developments in international capital markets. part of the appreciation in 2002 may also be due to higher oil prices. in a highly uncertain situation and with fears of war in iraq, the norwegian krone, buoyed by a relatively high interest rate and oil wealth, may have been regarded as an attractive alternative. investment in nok may have been considered a good hedge against a downturn in the world economy as a result of fears of war and high oil prices. since december last year, the interest rate differential between norway and other countries has narrowed by about 3 percentage points. since the beginning of 2003, the krone measured in terms of the trade - weighted exchange rate index ( twi ) has depreciated by 11 per cent. at the beginning of the 1990s, the norwegian economy was in a deep recession. production was far below capacity. when growth in the economy picked up, capacity utilisation increased. the output gap shows the difference between actual gdp and the level indicated by trend growth - estimated at close to 2½ per cent in norway. around 1996, there was full capacity utilisation, and the output gap, as we normally measure it, closed. subsequently, costs increased and prices for goods and services produced for the norwegian market accelerated. the upturn peaked in 1997, with gdp growth approaching 5 per cent. in 1997 and 1998 the economy shifted from an upturn with high growth rates to an expansion with lower growth but low unemployment, labour