is a parameter that expresses how much weight is given to stable output versus low and stable inflation. If is greater than 0, this is often referred to as flexible inflation targeting. 8  BIS Review 10/2007  Thirty to forty years ago, economic policy was widely regarded as an optimal control problem where the authorities could minimise society’s loss function directly and mechanically. Economic policy could in a sense be viewed as an engineering art. However, in 1977 Finn Kydland and Edward Prescott warned against this approach to economic policy conduct.4 In their work, for which they were later awarded the Nobel Prize, they showed that if the authorities in each period attempt to optimise on a discretionary basis, a suboptimal equilibrium may arise. The reason lies in economic agents’ expectations formation. Kydland and Prescott argued in favour of a rule-based policy, where policymakers commit to a certain pattern of behaviour. They also pointed out that it would generally be tempting to "reoptimise" at a later time and thereby ignore earlier promises. This temptation is often referred to as the "time inconsistency problem". For a rule-based policy to be successful, it must be credible so that economic agents can fairly safely assume that decision-makers will actually follow their announced response pattern. Norway’s experience of various fixed exchange rate regimes during the post-war period provides a good illustration of the difference between discretionary policy and commitment policy. In the period 1946-1971, the krone was pegged to the US dollar.
Let me attempt to illustrate the gains of committing to a response pattern rather than pursuing a purely discretionary policy. We have developed tools that allows us to find interest rate paths that minimise the loss function, given a model of the economy’s functioning and given economic shocks. Within the framework of a small macroeconomic model, we have estimated the magnitude of the shocks to which the Norwegian economy has been exposed over the past 10-15 years. Under the two assumptions about monetary policy, discretion and commitment, we have estimated how large the variance of output and inflation will be over time. We have assumed that the economy is exposed to the same shocks as in history. Let me emphasise that this exercise is only meant as an illustration based on a stylised economic model. 10  BIS Review 10/2007  The chart shows the variance of inflation on the vertical axis and variance of the output gap on the horizontal axis. By minimising the loss function that I presented above under discretion and commitment respectively, we obtain different combinations of the variance of inflation and the variance of the output gap. By varying the weight on the output gap, lambda, in the loss function, we obtain a line for each strategy. The lines represent the minimum loss that can be achieved under commitment and under discretion.