Before I discuss Norges Bank’s suite of models in greater detail, I would like to look at a few key macroeconomic variables and their interaction. Studying fundamental statistical relationships provides important insight into the functioning of the economy. Along with the theoretical foundation, such insight is one of the most important building blocks of a good analytical apparatus for implementing monetary policy. Let me begin by taking a look at the relationship between output and inflation. In recent years, consumer price inflation (CPI) has fluctuated between 0 and 3 per cent. Mainland GDP growth has also fluctuated, giving rise to economic cycles. The chart shows developments in the two variables measured as deviations from long-term trend growth, in other words an “inflation gap” and an “output gap”.4 When the output gap is positive, the  4  The gaps express deviations from estimated trends in seasonally adjusted figures for mainland GDP and CPI adjusted for tax changes and excluding energy products (CPI-ATE), respectively. The trends are estimated using a Hodrick Prescott (HP) filter on quarterly data with λ=40000. The output gap in this analysis is a technical estimate and does not fully correspond with the output gap in Norges Bank’s Monetary Policy Report. 6  BIS central bankers’ speeches  economy is usually in an upturn, while the economy is in a downturn when the gap is negative.
Thereafter the model takes over and the interest rate gradually falls back, in line with the model’s estimated reaction pattern. In the course of a couple of years, the interest rate has returned to its starting point.9 As the chart shows, the degree of spread in the results is considerable. If we were to draw a fan chart, or confidence intervals, around each model, it would become clear that the uncertainty is even greater than the spread alone indicates. The results must therefore be interpreted with caution. If we were nevertheless to draw a conclusion on this basis, it must be that an interest rate increase will dampen GDP growth in the course of the subsequent year – all else being equal. Somewhat further ahead, inflation will also recede. As the interest rate returns to normal, GDP growth and inflation will pick up again. Our macroeconomic model NEMO has a more precise theoretical construction than the VAR models. NEMO is a dynamic stochastic general equilibrium (DSGE) model, and has many features that are similar to corresponding models in other central banks. It describes the behaviour of households and firms. Economic agents are forward-looking when making decisions so that expectations are of significance. There are three economic agents: households, firms and a central bank. Households demand goods and supply labour. They assess how much to spend relative to saving and how much they should work subject to their budget constraints.