Developments in the 1970s and 1980s showed that a higher rise in costs in Norway relative to other countries leads to a slacker labour market. This will also be the case this time. 5) Pressures on the exchange rate of commodity-based economies There is a correlation between price inflation and the exchange rate. As mentioned, the exchange rate has a significant influence on prices and costs through its effect on import prices. Furthermore, a precondition for maintaining a stable exchange rate against European countries is that inflation in Norway is over time on a par with the inflation rate prevailing in these countries. The high rise in costs in 1998 was probably the main factor that weakened confidence in the krone. International conditions also played a significant part. In 1998, the world economy was hit by the financial crisis in Asia, Russia and Brazil, falling commodity prices and widespread unrest in international financial markets. The Asian crisis proved to be more serious and prolonged than envisaged, and the contagion effects were more severe than most observers had anticipated. Weaker global demand contributed to a sharp fall in commodity prices, which in turn had a severe impact on commodity-based economies such as Norway, Canada, New Zealand and Australia. For all these countries, the terms of trade worsened and exchange rates depreciated. The Asian crisis also made investors more cautious, with an outflow of investment from countries perceived as risky.
After it became clear that Russia would not, in practice, be servicing its foreign debt, market participants became highly risk-averse. The unrest spread to European BIS Review 10/1999  –6–  financial markets and Norway. Investors fled to safe-haven countries such as Germany, the US and Switzerland, and the currencies of countries with less liquid and more volatile financial markets depreciated. This included countries such as Norway and Sweden. The Norwegian krone depreciated sharply from around 101 against the ECU index at the beginning of the year to 115 in October, or the weakest rate since the objective of exchange rate stability against the ECU was adopted. 6) Monetary policy in 1998 Norges Bank responded to the sharp depreciation of the krone by raising its key rates in several steps in 1998. These rates were first raised in March, after the krone weakened in the first three months of the year from 101 to about 103.5 against the ECU index. The krone then appreciated slightly and stabilised for a period. Pressure on the krone increased during the summer. Norges Bank responded by raising its key rates on six further occasions. Following the last increase on 25 August, the deposit rate and the overnight lending rate were 8 and 10 per cent, respectively, i.e. 4.5 percentage points higher than at the beginning of 1998. It is difficult to predict the direct short-term effect of changes in interest rates on the exchange rate.