Independent central bank, inflation target and openness This time inconsistency problem which affects economic policy was first noted by Finn Kydland and Edward Prescott in the late 1970s. 3 One proposal that was put forward to address this problem was to introduce independent central banks which build up credibility by succeeding in maintaining low inflation and having realistic ambitions with regard to stabilising resource utilisation. To do this, the central banks must be able to take quick and sometimes unpopular decisions. If a central bank succeeds in attaining credibility so that inflation expectations are stable, there is some scope for also taking into account developments in the real economy. 4 It is thus also important from a stability perspective to find a means of attaining credibility and stable inflation expectations. As one of the steps to achieving this many central banks, including the Riksbank, introduced explicit inflation targets in the 1990s. In practice, most central banks now conduct flexible inflation targeting to attain the inflation target and also stabilise resource utilisation. This means that the central bank is not prepared to attain the inflation target in the short run at any cost. The Riksbank’s aim is that if inflation deviates from target it shall normally be brought back on target within a couple of years. In the case of large deviations it may take longer before the target is attained so that the effects on the real economy are not excessive. Because monetary policy works with a lag, the decisions must be based on forecasts.
The influence of monetary policy in the short and long run – research At the end of the 1950s the economist A. W. Phillips found a negative relationship between unemployment and inflation by studying data from the UK for the period 1861-1957 1 , a relationship that is usually referred to as the Phillips curve. This shows that higher employment can be achieved at the cost of higher inflation. It was thus long believed that one could "buy” long-term lower unemployment by pushing up inflation. However this relationship was empirically proved not to hold in the long run. In the 1970s, for instance, there were periods with both high unemployment and high inflation, what is known as stagflation. The relationship was also tackled from a theoretical angle. In a famous article from the late 1960s Milton Friedman discussed what monetary policy can and cannot achieve. 2 His view was that in the long run monetary policy is unable to affect real economic variables such as unemployment and GDP. However, it can affect nominal variables such as the exchange rate and price level. In the long run there is a "natural” level of unemployment that is dependent on the functioning of the labour market. If monetary policy tries to push down unemployment below this "natural" level, it will only result in higher inflation. Monetary policy therefore risks becoming a disturbing factor in the economy.