Do interest rates really respond to financial stability concerns? : an analysis of monetary policy in Norway 1999-2018

Abstract

This master thesis estimates monetary policy reaction functions for the Norwegian economy from 1999 to 2018 using a Taylor rule. In a Taylor rule the interest rate is typically set dependent on inflation and the output gap. Our primary focus is to determine whether Norges Bank also target key financial indicators when setting the interest rate. We study, therefore, whether Norges Bank has set the interest rate over and above what inflation and output gap developments, would suggest, in their attempt to mitigate the build-up of financial imbalances. We find that a model containing financial variables, using different specifications and different estimation methods, are not able to outperform a Taylor rule containing only inflation and output gap concerns. Furthermore, high degree of policy inertia makes differences between the interest rate predictions almost negligible. However, we find a surprisingly high output gap coefficient for the whole sample, which may indicate that Norges Bank include financial stability concerns to their monetary policy. On the other hand, when we concentrate the study and look at post-2011 results (the year Norges Bank changed governor), we receive a much lower output coefficient. Post-2011 results suggest that the interest rate setting has been more concerned with the exchange rate, foreign interest levels and low output, rather than working purposefully to counteract the build-up of financial imbalances.