888 Macroeconometric Modeling for Policy
Hence, stabilization of inflation after a supply shock may represent a formidable
challenge to monetary policy.
The recent monetary history of Norway has demonstrated the relevance of this
analysis: since mid 2003, core inflation rate has been consistently below the target
of 2.5%, for long periods less than 1%, despite determined interest rate cuts in
2003, and no interest rate increases before July 2005, and then only gradually and
in small steps.
The interest rate multiplier on inflation is shown in panel (a) of Figure 17.5. Panel
(f) shows that the effect first goes through theexchange rate channel: the impact
multiplier is a 3% appreciation, and in steady state there is an appreciation of
1.2%, thus illustrating equation (17.57). Panel (e) shows that import price growth is
affected in the same way as the exchange rate (see equation (17.59)), but the impact
effect is smaller. Panels (b), (c) and (d) show thelabor marketanddemand channels.
Wage growth is reduced, as predicted by (17.58), leaving real wage growth unaf-
fected in steady state, as this is determined by productivity growth. Unemployment
increases, since real interest rates increase, while negative GDP growth follows from
increasing real interest rates and appreciation of the real exchange rate.
17.4.2.2 Fitting the facts
In this section we document how well the econometric model NAM explains the
evolution of important endogenous variables over the 17-quarter period 2003(3)–
2007(3).
The solutions are conditional upon the actual values of the non-modeled
variables.^15 Experience has shown that particularly important explanatory vari-
ables are foreign interest rates (R∗andR∗B) and consumer (p∗) and producer prices
(pi∗). Domestic government expenditure (g) and electricity prices (pe) are also very
important for the overall fit of the model. Finally, the oil price (in $US) is a highly
relevant explanatory variable, mainly through the market for foreign exchange.
The interest rate has been the instrument of monetary policy during the solu-
tion period. We therefore use the (more) closed version of the model, where the
domestic money market interest rate is estimated as a function of the core inflation
gap and the unemployment rate gap in equation (17.46).
Figure 17.6 shows that NAM generates the features of the macroeconomic devel-
opment. Inflation in panel (a), the rate of unemployment in panel (b), GDP
growth in panel (d), and the money market interest rate in panel (g) are very
well explained by the model solutions. The graph of actual and simulated nominal
currency depreciation in panel (i) shows that movements in the exchange rate are
also well explained, brought about by the interest rate differential and equilibrium
correction with respect to the real exchange rate – which is shown in panel (f).
17.4.2.3 Shock analysis with dynamic multipliers
Next, we investigate how the economy, according to the model, is likely to respond
to shocks. We use the same model version as in section 17.4.2.2. Amongst the many
shocks of interest to a small open economy, we here consider a negative foreign
price shock. The deflationary 5% shock occurs in 2007(1), and Figure 17.7, panels