Norges Bank

Knowledge bank

How does the policy rate influence the economy and inflation?

Changes in the policy rate influence activity levels across the whole economy and thereby inflation. The impact is transmitted through various channels and often with some lag.

To simplify, we can say that the policy rate influences the economy and inflation through a demand channel, a foreign exchange channel and an expectations channel.

The demand channel

When interest rate levels rise, households and businesses have less money for consumption and investment. In addition, it becomes less interesting for many firms to invest because loans have become more expensive and demand for the goods and services they produce has fallen.

Lower demand may lead to lower output and fewer jobs (the number of employed persons declines and unemployment rises), which can curb wage and price inflation.

Consequently, a policy rate increase, transmitted through the demand channel, as a rule leads to inflation becoming lower than would otherwise be the case.

Foreign exchange channel

The krone exchange rate is an important component of the price Norwegian consumers have to pay for goods and services produced abroad and in the price paid abroad for goods and services produced in Norway.

If the policy rate is raised in Norway at the same time as the rates in other countries remain unchanged, demand for NOK might increase, and the krone may appreciate. This means that the goods we import into Norway become cheaper in NOK terms.

At the same time, exports from Norway become more expensive in foreign currency terms. Firms that rely on exports to foreign countries will then experience a fall in revenue. This will contribute to reducing the pressure on wages and prices for these firms.

Consequently, a policy rate increase, transmitted through the foreign exchange channel, leads to cheaper imported goods and less pressure on wages and prices.

The expectations channel

Inflation expectations play a role when the social partners in Norway negotiate wages. Employees will seek to maintain their purchasing power. If employees expect prices to rise considerably, they will generally demand higher wage increases than if they expect low inflation.  

In addition, firms attach importance to expected price and wage inflation when setting prices for their goods and services. Inflation expectations also influence exchange rate movements, which in turn influence prices and wages. Expectations of high inflation therefore contribute to high inflation and vice versa.

Published 12 April 2019 15:58