Another example of problems with CPI is as follows: If the Government tightens fiscal policy with a VAT increase, CPI rises, as VAT has a direct effect on inflation measured in this way. The effects of  BIS Review 59/1999  4  such measures, interest rate changes and tax changes are temporary. These normally result in one-off effects on the price level. However, it cannot always be right to tighten monetary policy and increase the interest rate because inflation has been increased by a VAT increase which in time will dampen demand and lower the level of activity and capacity utilisation. In time, inflation will be dampened by the VAT increase, although this takes place by means of an increase in prices – bear in mind though that this depends on inflationary expectations not being affected. A different situation arises then. This shows that CPI movements must be interpreted and analysed when deciding on monetary policy. Temporary effects on the price level should not initiate changes in monetary policy. The Riksbank is therefore studying a number of other indexes that do not have the weaknesses of CPI in the aspects taken up here. A harmonised index, HICP, is being designed for the entire EU area. This is used by the European Central Bank, ECB, and this measure does not include interest rate changes, although it does include indirect taxes and subsidies. Another index, UNDIX, measures the “underlying” inflation by excluding the direct effects of indirect taxes, as well as interest effects.
It can therefore be said that employment and capacity utilisation directly affect the Government’s monetary policy to the extent that compliance with the inflation target only takes place gradually within a period of two years. This is to avoid too great fluctuations in the real economy – in employment and capacity utilisation otherwise. However, unemployment and capacity utilisation affect inflation and are therefore included as components of inflation forecasts. These circumstances therefore also play an indirect role for the Riksbank’s monetary policy. The exchange rate is not an objective for Riksbank policy although it also has a direct and indirect effect on inflation. An appreciation of the exchange rate will have, all other things being equal, an immediately dampening effect on import prices. As import prices are included in CPI, inflation will be reduced. The exchange rate will affect inflation indirectly by affecting demand. A higher real exchange rate reduces exports and thereby reduces the level of activity with some time lag. This indirect effect tends to reduce inflation in the somewhat longer run. Supply is also affected by the exchange rate in time by (initially) affecting import and export prices, which eventually spreads to other prices and wages. By the direct and indirect effect of the exchange rate on inflation, the exchange rate plays a role for the Riksbank’s policy in those cases when a change in the exchange rate is expected to be, or proves to be durable.