If the interest rate is increased to the extent that output is reduced to a level that is consistent with stable inflation over time, inflation may be too low as a result of an appreciation of the exchange rate in the short term. A trade-off must be made in the short term between the inflation target and stability in the real economy. A cost shock, which fuels inflation and at the same time reduces output and employment, leads to a more marked conflict in the short term between the inflation target and stability in the real economy. Different types of disturbances will often occur at the same time, and the central bank must continuously make trade-offs between variations in output and employment on the one hand and variations in inflation around the target on the other. Given that inflation over time shall be close to the target, these trade-offs are at the core of flexible inflation targeting. In the theoretical literature, making trade-offs between price stability and stability in the real economy is often described as minimising a loss function, where variations in output and variations in inflation are included.7 The central bank shall then choose the path for interest rates ahead that minimises the discounted “losses” in all future periods. The loss in one individual period will be:  In the equation, denotes inflation, * the inflation target and (y-y*) the output gap. The loss function thus includes the deviation between output and the output potential and between inflation and the inflation target.
Projections for imported price inflation may therefore be said to be characterised more by Knight uncertainty for a period ahead. Monetary policy under uncertainty was one of the many topics discussed in the report Norges Bank Watch 2003, where our policy response pattern and communication were evaluated in the light of the theory of monetary policy under uncertainty. This was useful input and constructive criticism which we will keep in mind in our future work. Norges Bank Watch 2003 points out, for example, that we should make a clearer distinction between additive uncertainty and multiplicative uncertainty. This distinction is most clearly reflected in our economic models. The uncertainty associated with the exogenous variables is called additive uncertainty. Examples of additive uncertainty are add factors in our economic models and other exogenous factors such as fiscal policy and the oil price. Uncertainty about the actual functioning of the economy may, however, lead to multiplicative uncertainty. Multiplicative uncertainty often involves uncertainty about the structural parameters in the model, such as the effect of the interest rate on demand and the exchange rate and the slope of the short-term Phillips curve.