In general, the policy rate influences the economy and inflation through a demand channel, an exchange rate channel and an expectations channel.

The demand channel

When the interest rate level goes up, households and businesses have less money to spend on consumption and investment. In addition, many businesses will find it less attractive to invest, as loans are more expensive and demand for their goods and services have fallen.

Less demand can lead to lower output and employment (employment falls and unemployment rises). In turn, this could dampen wage and price inflation.

This means that raising the policy rate will have an effect through the demand channel, generally resulting in lower inflation than would otherwise have been the case.

The exchange rate channel

The krone exchange rate is an important component in the price we pay for goods and services produced abroad and in the price foreigners have to pay for goods and services produced in Norway.

If the policy rate is raised in Norway while it is kept unchanged in other countries, demand for Norwegian kroner could rise and the krone could appreciate. This means that goods imported to Norway become cheaper when measured in krone terms.

At the same time, Norwegian goods sold abroad will be more expensive when measured in foreign currencies. This may result in lower income for export businesses, and dampen the pressure on wages and prices from these businesses.

This means that raising the policy rate will have an effect through the exchange rate channel, resulting in cheaper imported goods and less pressure on wages and prices.

The expectations channel

Inflation expectations are important when employers and employee representatives negotiate wages. Employees want to maintain their purchasing power. If they expect that prices will increase substantially, they will normally demand higher wage increases than if they expected low inflation.

In addition, businesses give weight to expected wage and price inflation when pricing their goods and services. Inflation expectations also have a bearing on exchange rate developments, which in turn impact prices and wages. High inflation expectations thereby contribute to high inflation, and vice versa.