How shall monetary policy be designed if there is a risk for exaggerated indebtedness and overheating? A decision-making rule the Riksbank sometimes uses to motivate its monetary policy decisions can in simple terms be described as follows: when inflation exceeds the target in a one-to-two year horizon, then the interest rate is increased. Interest rate increases reduce the demand for goods and services, which in turn reduces inflationary pressure. In our simple conceptual framework, inflationary pressure is then assumed to vary with the use of resources in the economy. When there is free capacity, inflationary pressure is low in the absence of so-called shocks. When demand is so high that it exceeds the level that is compatible with the long-term production path, inflation tends instead to exceed the target. The line of reasoning is based on inflationary expectations being established close to the target for monetary policy. Price increases when demand is strong may for instance depend on bottlenecks being created in some part of the production chain. As the company in this situation, cannot improve its profits by increasing its volume of sales, profit margins are increased by price increases. Shortage of labour also increases the risk for excessively high wage increases. The result will be higher inflation. If we strictly apply such a simple rule for decision-making, we shall then disregard the risk of building up of financial imbalances and overheating as long as inflation is not deemed to exceed the target during the forecast period.
On 1 January 1999, a new Riksbank Act came into force. It states that the goal for the Riksbank’s activity is to maintain stable prices. The Riksbank shall also be responsible for a secure, efficient payment system. In the preparatory legal material on the Act, it is also further stated that the Riksbank, without setting aside the price stability target, shall also support the objectives of general economic policy with a view to achieving sustainable growth and high employment. The price stability goal has then been confirmed by law. The Riksbank’s Executive Board is responsible for making the price stability goal operational and designing the framework for monetary policy. Among other things, this means that the Executive Board decides on how the price stability goal is to be defined and over what period price stability is to be maintained. The Executive Board of the Riksbank has decided that price stability shall be defined as an annual increase in the consumer price index of 2% with a tolerance interval of plus/minus one percentage point. If the consumer price index is affected by factors that are considered to only have a temporary effect on CPI, the Executive Board has agreed that we shall be able to disregard this. The reason is that monetary policy otherwise risks leading to unnecessary fluctuations in employment and production. A lot has been achieved although some things remain to be done Economic policy has been very successful in many areas during recent years.