Figure 1 shows how an unexpected "exogenous" increase in the policy rate affects inflation and GDP in two macroeconomic models adapted to Swedish conditions: the Riksbank's model Maja and the National Institute of Economic Research’s model Selma.^[4] See Corbo and Strid (2020) and Akkaya et al. (2021), respectively, for documentation of the two models. These two models are similar in many ways, but one difference is that Selma contains a more detailed structure for fiscal policy. Maja is estimated on Swedish data, while Selma is a calibrated model, based in many dimensions on Maja's parameter estimates.

Figure 1. Effects of an interest rate increase in two models Percentage points and per cent respectively

The figure shows the effects of an unexpected change in monetary policy that increases the policy rate by an average of one percentage point over a year. After that, monetary policy returns to its normal pattern. As mentioned above, the two models are quite similar, and the effects on inflation and GDP are also very much the same. We can see that if the policy rate is raised by one percentage point over a year, inflation falls by an average of just under 0.15 percentage points over the first three years, while GDP falls by an average of 0.5–0.75 per cent per year. To reduce inflation by one percentage point, the policy rate would then have to be raised by as much as seven percentage points.

But such an interpretation can lead to incorrect conclusions. The reason why monetary policy has such small effects on inflation in Figure 1 is that the change in interest rates is not particularly persistent. We see this if we study the five-year real interest rate, which in the models is an average of the expected policy rate over the next five years, adjusted for expected inflation over the same period. It rises only marginally, by 0.3 percentage points over the first year. This very small increase is mainly due to the expectation that the policy rate will return relatively quickly to its initial level. Thus, despite the one percentage point increase in the policy rate, longer-term policy rate expectations, or longer-term market rates, are hardly affected at all.