In the same manner, interest rates will normally need to be raised in situations in which future inflation tends to get excessive as a consequence of a too high resource utilization. Consequently, when an inflation forecast shows that future inflation does not appear to be in line with the target, policy must be altered. In these situations there is a balancing problem. The question is how forceful the interest rate change should be. If it is dramatic, the adjustment in the rate of inflation to the established target may be faster, but the repercussions in the short term in the form of fluctuations in production and employment will probably be bigger also. Figure 1  P r ice Sta b ilizatio n : Alte r n a tive Pa th s  πt  2%  t+4  t+8  t  The reasoning can be made clear with a simple diagram (Figure 1). By choosing interest rate path 2 rather than path 1, the adjustment to the inflation target will be somewhat slower; however, the development in the economy will also be less spasmodic. BIS Review 56/1997  -3-  The fact that the Riksbank--when the price stability objective was introduced in 1993--chose to postpone its application for about 2 years (the decision that evaluation would only be made when the direct effects of the krona’s weakening had died away in 1995) can be said to have been a way of taking into consideration the above reasoning.
The Exchange Rate In small, open economies, the exchange rate has an important influence on inflation. At the same time, it is a variable that has fluctuated considerably in recent years for reasons which have not always been easy to foresee and interpret. How changes in the exchange rate should be handled in practical policy depends above all on how lasting a change in the exchange rate is judged to be. More enduring changes that have an effect on inflation forecasts obviously have to be taken into account In order to decide on the duration and what is a reasonable reaction, one normally has to know what brought about the change. Several different cases can be discerned: A nominal change in the exchange rate can be a result of a change in the real equilibrium exchange rate. This case is in principle simple to manage since it normally does not lead to a changed picture of inflation and thereby does not occasion any specific policy measures. Changes in the real equilibrium exchange rate have not been an especially common reason for changes in the exchange rate in recent years, at any rate since the krona fell in connection with the changeover to a flexible exchange rate in 1992. A change in the nominal exchange rate may also have to do with a change in the long-term view of the steadfastness in economic policy, or what is termed credibility.