Monetary policy, cyclical fluctuations and competitiveness

1. Introduction

Thank you for giving me this opportunity to discuss the relationships between monetary policy, cyclical developments and competitiveness. There has been some debate about monetary policy this summer. Part of this debate has focused on the role monetary policy can and should have in smoothing fluctuations in the real economy and safeguarding competitiveness in the Norwegian business sector. Some have maintained that we place too much weight on reaching the inflation target. Statements like this should be discussed in the light of what monetary policy can be used for and of the broad effects on the economy of various monetary policy objectives. Only when we have clarified our options, can we discuss whether the emphasis on the inflation target is "too great", "too little" or "just right". I hope to be able to offer some clarification today. I think it will also become clear that Norges Bank in its implementation of monetary policy consciously seeks to avoid unnecessary disturbances in the real economy. First of all, I would like to present a theoretical outline of how monetary policy works and then indicate some relevant and realistic monetary policy objectives.1 I will then discuss and assess Norwegian monetary policy on this basis, including the trade-offs we face in economic policy. It is important to note that it is a question of trade-offs. We simply cannot have everything we want.

2. How does monetary policy influence the economy?

Monetary policy affects the economy through several channels, together referred to as the transmission mechanism of monetary policy. In a closed economy, monetary policy mainly works by influencing demand through changes in the real interest rate. In an open economy, monetary policy also works through changes in the exchange rate. Let us make a stylised review of what happens if the central bank raises the key interest rate. In the short and medium term, prices are relatively rigid. As a result, the short and longer real rates of interest also tend to increase when the nominal interest rate is raised. In addition, there is both a nominal and a real appreciation of the exchange rate.download