From 1986 to 1992 Norway had a fixed exchange rate system with a defined central rate with fluctuation margins. This system was abandoned in 1992 after extensive speculation against the krone during the period of unrest in European exchange markets. Following the decision to allow the krone to float on 10 December 1992, the guidelines for monetary policy were revised. Monetary policy was subsequently oriented towards exchange rate stability, but without stipulating a central rate with fluctuation margins. The krone depreciated slightly immediately after the crisis, but then remained stable without extensive use of Norges Bank’s instruments. Since 1996, the exchange rate has fluctuated more widely. There may be several reasons for this. During part of this period, the government budget has not contributed sufficiently to smoothing growth in domestic demand and production. Wage inflation in 1997 and  BIS Review 121/1999  6  1998 was higher than in other countries. Turbulence in international financial markets has also had an important contagion effect on the krone. In addition, oil revenues have fluctuated, which may have affected investors’ expectations regarding future developments in the Norwegian economy.
Suppose that price and cost inflation in Norway were allowed to be higher than in the euro countries. The nominal exchange rate would then have to depreciate in order to keep the real exchange rate constant over time. Thus, stabilising inflation at around the level aimed at by the ECB is a means of achieving exchange rate stability against the euro. In a situation with the prospect of increased inflationary pressure and a depreciating exchange rate, an increase in the interest rate may at the same time bring the exchange rate back towards its initial range and reduce inflationary pressure through lower demand and lower imported goods inflation. This in turn will contribute to long-run stability in the exchange rate. Similarly, with an appreciating exchange rate and a low inflation and activity level in the economy, a lower interest rate will contribute to stabilising the exchange rate in both the short run and the long run through a stable inflation level. On the other hand, we can think of situations where we would need to set a high interest rate in order to keep the exchange rate close to the initial range in the short run, creating a deflationary recession in the economy. Normally, a deflationary recession will lead to a weakened krone exchange rate, which means that the high interest rate set to keep the level of the exchange rate unchanged in the short run in itself will induce exchange rate instability in the long run.