Recently we have extended the model to include financial frictions and also an explicit banking sector and a housing market. As soon as we abandoned an exogenous assumption of future key policy rates, we had to take a stand on how to formulate monetary policy within our core model. Analytically, deriving the monetary policy reaction pattern with a loss function is a useful and practical approach. We have developed an improved apparatus for solution algorithms for DSGE models in order to be able to solve for the endogenous interest rate path in different ways and under different assumptions. The interest rate path that we derive from the model analysis serves as a benchmark for the policy discussions of the Executive Board. The analytical loss function that we use in NEMO to solve for this path reflects our criteria for an appropriate interest rate path. The first criterion is that the interest rate should be set with a view to stabilising inflation at target or bringing it back to target after a deviation has occurred. The second criterion is that  8  For details, see Qvigstad, J. (2005): “When does an interest rate path “look good”? Criteria for an appropriate future interest rate path – A practician’s approach,” Norges Bank Staff Memo 6/2005. 9  The key policy rate is the interest rate on banks’ overnight deposits in Norges Bank. 10  Norges Bank has developed a system, SAM (System for Averaging Models), for averaging short-term forecasts for inflation and mainland GDP provided by different models.
This issue is on our research agenda. We have initiated a three-year research project, where we will seek to review different aspects of our inflation targeting framework, including the question of how to take financial stability into account. Moreover, for a small open economy, large terms of trade shocks may represent a particular challenge, also for monetary policy. In our search for answers and our efforts to steadily improve our implementation of flexible inflation targeting, we look to academia. Therefore, let me again emphasise how much I appreciate the opportunity to be here today. Thank you for your attention. 8  BIS central bankers’ speeches  BIS central bankers’ speeches  9  10  BIS central bankers’ speeches  BIS central bankers’ speeches  11  12  BIS central bankers’ speeches  BIS central bankers’ speeches  13