Norway: Monetary policy curbs inflation via exchange rate
A Norges Bank working paper finds that contractionary monetary policy shocks lead to a gradual and persistent decline in inflation in Norway. The study highlights the importance of exchange-rate and demand-side channels in this small open economy.
Exchange rate's disinflationary pull
Contractionary monetary policy shocks in Norway lead to a gradual and persistent decline in inflation, a finding robust across various identification strategies and estimation methods.
The disinflationary effects are most pronounced for imported prices and are accompanied by an appreciation of the Norwegian krone.
This highlights the crucial role of exchange-rate transmission in a small open economy.
Domestic inflation, house prices, and economic activity also decline over time, indicating that both exchange-rate and demand-side channels contribute to lower inflation.
The study uses high-frequency monetary policy surprises around Norges Bank announcements as external instruments, employing Proxy SVAR and Local Projection Instrumental Variables (LP-IV) methods to isolate exogenous policy shocks.
This approach provides credible causal evidence, separating policy variation from endogenous responses to macroeconomic conditions.
Norway's unique transmission channels
The study addresses a central question in macroeconomics: how monetary policy affects inflation, particularly in a small open economy like Norway.
Norwegian households are highly exposed to floating interest rates, leading to rapid pass-through to borrowing costs.
Combined with free capital mobility, a floating exchange rate, and substantial exposure to imported inflation, these features suggest multiple transmission channels beyond domestic demand.
The paper also acknowledges a recent public debate in Norway questioning whether higher interest rates might themselves contribute to inflation through increased financing costs, reflecting broader uncertainty about monetary policy's practical operation.
The research aims to provide clarity on these mechanisms.
Robust evidence, complex reality
This paper provides robust empirical backing for the conventional view that monetary policy effectively tames inflation, even amidst public skepticism.
Its strength lies in the rigorous identification of causal effects and the detailed breakdown of transmission channels, particularly the exchange rate.
However, the documented heterogeneity across inflation components and household expectations underscores the complex and nuanced reality of policy impact, demanding careful consideration beyond aggregate figures.