Besides these more fundamental explanations with links to the theory of purchasing power parity, there are numerous notions connected more or less closely with the flows in currency markets. The nominal exchange rate is the price of a currency; like prices of other goods, this price is naturally affected from time to time by more or less temporary fluctuations in demand and supply. It is explanations of this type that market players are most prone to put forward for short-run exchange-rate fluctuations. The most general flow-related explanation is probably the short-term interest rate differential. Textbooks teach that international currency flows and nominal exchange rates are susceptible to differences in current and expected monetary policy. Today, when monetary policy throughout the industrialised world is focused on price stability, so that interest rate differentials between countries are tending to decrease, the explanatory power of this variable is presumably weaker. Another factor that has been of major importance for nominal exchange rates from time to time is the state of the government finances. High and growing government debt leads to expectations of a suspension of payments or a monetary policy realignment in a more inflationary direction. That in turn results in a depreciation of the exchange rate. The picture in Sweden Since 1975 the Swedish krona has weakened in nominal terms by as much as 90 per cent. But at least half of this depreciation can be explained by Sweden’s higher inflation. And in this respect there has been a decisive change.
Besides exchange rate movements, these include the development of world market prices and the level of resource utilisation in Sweden. The importance of domestic resource utilisation has to do, for example, with the fact that most imported goods are handled and processed in Sweden before reaching consumers and that raising prices is generally more difficult when demand is weak. When we look back at the 1990s in order to draw conclusions about the future, all these factors have to be born in mind. Let me cite a couple of examples. During 1994 and much of 1995 a comparatively weak exchange rate led to rising import prices but the pass-through to consumer prices was smaller than the Riksbank had anticipated. One explanation was that capacity utilisation turned out to be below the Riksbank’s assessment both because it was overestimated initially and because demand was weaker, partly as a result of the Riksbank’s interest rate hikes. Another explanation was the krona’s marked appreciation towards the end of 1995. In 1998 the krona weakened again in connection with the Russian crisis. On a 12-month basis the depreciation amounted at most to about 10 per cent. Even so, import prices did not rise; on the contrary, they actually fell a good way into 1999. This largely reflected the factor that triggered the crisis: one of the largest price falls in modern times in commodity markets, including a barrel price of oil down towards USD 10. The result was markedly decreased international export prices - the equivalent of our import prices.