Similarly, the opposite situation may occur, BIS Review 121/1999  10  where a low interest rate is required to keep the exchange rate stable in the short run, creating inflationary pressure in the economy. In both situations, however, a policy aimed at stabilising the exchange rate in the short run will weaken the basis for exchange rate stability over time. Hence, Norges Bank cannot with open eyes set interest rates to levels where monetary policy in itself contributes to a higher inflation or a deflationary recession, which would undermine the confidence of the krone. Chart 11 Preconditions for exchange rate stability  • Inflation at the level of the Euro countries • Monetary policy should not contribute to a deflationary recession  Legg inn filadresse her  If price and cost inflation is in line with the level aimed at by the euro countries, one of the fundamental conditions for exchange rate stability is satisfied. In spite of this, the exchange rate may be perceived as “too strong” or “too weak” in relation to the initial range. This may be due to conditions in the real economy, which could imply a real appreciation or real depreciation of the krone. The background for such changes in the exchange rate may be that the cost competitiveness of Norwegian industry has to be adjusted and that the equilibrium range of the krone exchange rate has changed. In this situation Norges Bank should carefully evaluate the reasons for exchange rate movements.
Interventions influence the supply of kroner in the exchange market. A change in interest rates influences both conditions in the exchange market and total demand and production. Monetary policy may thus influence price and cost inflation through both these channels. In Norges Bank’s experience, extensive exchange-market interventions have yielded poor results. If the central bank intervenes heavily to defend the krone, this may evolve into a game situation in which market participants perceive central bank interventions as an interesting opportunity to make a profit. Market agents know that a situation in which the krone is being propped up because Norges Bank is intervening cannot be sustained. It is then tempting to take positions in the foreign exchange market against the central bank. This implies that heavy interventions may intensify the pressure on the krone over time, steadily increasing the necessary volume of interventions. If market participants assume that Norges Bank will use the interest rate to defend specific exchange rate levels, this may lead to a similar game situation. Norges Bank does not intend to behave in a way that will prompt such game situations. However, the Bank may use interventions to a limited extent if the exchange rate moves substantially out of line with what we consider to be reasonable on the basis of fundamentals, or in the event of exceptional short-term volatility in thin markets. In such circumstances, there is less risk of ending up in a game situation against exchange market agents.