Changes in the instrumental rate have an effect through the "exchange rate channel" partly by changes in the nominal exchange rate for the krona affecting the relative prices for net export. Higher interest rates should thereby strengthen the domestic currency and make domestic goods more expensive relative to other goods and vice versa. Higher interest rates thereby dampen export at the same time as import becomes cheaper and increases. Lower demand for domestic goods contributes to reducing the use of resources and subduing inflation. A stronger nominal exchange rate dampens consumer prices at the same time since part of consumption is directed towards imports when prices are dampened. However, lower import prices also increase the real purchasing power which per se contributes to increasing purchasing power. In economies with diversified industry an increase in the interest rate thus also leads via the exchange rate channel to lower inflation. The strength of the effect depends inter alia on income and price elasticities and on the composition and size of foreign trade. In certain cases the positive effect on incomes from stronger currency can even predominate and vice versa. Changes in the nominal exchange rate probably have less impact on import and export prices if the changes are not considered to be lasting. In a floating exchange rate regime, it is therefore probable that changes in the nominal exchange rate will not have such a great effect as in the case of a devaluation or revaluation in a fixed exchange rate regime.
The emphasis here is not on the effect of the interest rate changes on demand for money, for instance, to be able to make payments for investments and consumption, but directly on the effect that the interest rate has on the real demand. The channels that enable the steering interest rate to have an effect on the output gap can be categorised in different ways: The most important channel is probably the interest rate channel. A change in the steering interest rate directly affects the shortest market rate. The banks can normally finance a deficit and invest a surplus at that rate. The shortest market rate and market expectations on future changes in the instrumental rate therefore constitute the alternative cost of the banks' financing or the alternative 1  The quantity theory: ,m*=y+p-v shows a demand function for money in the logarithmic form of M/P=1 (Y,i) where M is the volume of money, Y is the real GDP, i is the interest rate and V=Y(M/P) is the rate of circulation, i.e. the velocity. 2  BIS Review 40/2001  return on the bank's loans and holdings of securities. The banks' lending rate and the interest rate on securities are therefore affected by the actual and expected instrumental rate. Monetary policy thus also has a direct effect on the interest rates encountered by the general public. i. Investment and consumption decisions are affected directly by the interest channel.