Iceland: Selected Issues
Author: International Monetary Fund
Publication Date:
27 Jul 1999
eISBN:
9781451819212
Language:
English
Keywords:
ISCR; CR; central bank; government approval; fixed exchange rate system; output gap; exchange rate regime; price level; Inflation targeting; Price stabilization; Exchange rate arrangements; Icelandic authorities
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This Selected Issues paper focuses on the European Monetary Union and the monetary policy framework in Iceland. It concludes that in terms of an exchange rate regime, the two most realistic options for Iceland are to continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. The paper also discusses a Scandinavian forecasting model for inflation in Iceland.

Abstract

This Selected Issues paper focuses on the European Monetary Union and the monetary policy framework in Iceland. It concludes that in terms of an exchange rate regime, the two most realistic options for Iceland are to continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. The paper also discusses a Scandinavian forecasting model for inflation in Iceland.

Main Websites for Icelandic Data

Data in the Statistical Appendices reflects information received at the time of the January 1999 Article IV consultation.

In some cases, more recent data can be obtained directly from internet sources. The main websites in Iceland are as follows:

The Central Bank of Iceland: http://www.sedlabanki.is/

The Ministry of Finance: http://brunnur.stjr.is/interpro/fjr/fjr.nsf/pages/english-index

The National Economic Institute: http://www.stjr.is/

Statistic Iceland: http://www.statice.is/

Iceland: Basic Data

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Sources: National Economic Institute; Central Bank of Iceland; and budget documents.

I. EMU and the Monetary Policy Framework in Iceland1

1. The emergence of the euro presents an opportunity for reassessing the monetary policy framework in Iceland. Since Iceland is not a member of EMU, and is not likely to become a member in the near future, this chapter does not attempt a cost-benefit analysis of EMU membership nor does it address any of the issues that concern either EMU members or EMU-outsiders (United Kingdom, Denmark, Sweden). The chapter focusses on EMU’s impact on current policies and sets out the options available to Iceland over the medium term. Although the wider impact on the Icelandic economy, including on institutions and policy making, the labor market, and the banking system, is also important, these issues are more general and have been discussed extensively elsewhere (see Emerson et al, 1991, Gros and Thygesen, 1992, and Masson, Krueger and Turtelboom, 1997, and references therein). Some of these issues will be touched upon briefly.

2. A committee of officials was established by the government of Iceland in 1997 to examine the impact of EMU on the Icelandic economy and the options for the future. In their report, as is the case here, the main focus was on the appropriateness of Iceland’s current exchange rate regime in the light of the advent of the euro and the possible enlargement of the euro area to include the United Kingdom, Denmark, and Sweden. Over the medium term, Iceland will have to decide whether it will continue with the existing arrangements or will instead consider bringing the country closer to EMU. Any decision will inevitably have to balance, on the one hand, the need for maintaining and enhancing credibility in pursuing monetary policy goals, against the desirability of retaining exchange rate flexibility to adjust to external shocks. The committee considered four options for the exchange rate regime: (i) a unilateral peg to the euro; (ii) a bilateral peg, equivalent to participation in ERMII; (iii) a currency board; and finally, (iv) the unilateral adoption of the euro as a legal tender. However, only the first two options were considered feasible and explored at some length. The unilateral peg to the euro was not deemed suitable for Iceland, as “The credibility of such an arrangement… would hardly exceed that of the existing arrangement”. The report commented favorably on the possibility of a bilateral arrangement with the European Central Bank (ECB) under which both parties, the ECB and the Central Bank of Iceland, would be obliged to intervene to limit the fluctuations in the krona/euro exchange rate.

3. This chapter discusses these choices and concludes that, in terms of an exchange rate regime, the two most realistic options for Iceland are: continue with the existing arrangement or adopt a unilateral peg to the euro. However, it is argued that both options entail the need for enhancing the independence of the central bank, which will require reforming the Central Bank of Iceland Act. In addition, it is argued that the objective of monetary policy has to be more clearly defined and included in the revised act. There are two more options besides exchange rate peg: inflation targeting and participation in the European and Monetary Union by joining the European Union. It is argued that these also will require changes in the Central Bank Act.

A. The Present Monetary Framework

4. Inflation in Iceland remained very high in the 1970s and 1980s. After an impressive disinflation performance, inflation was lowered to less than 2 percent in 1998 (Figure 1). Why did inflation remain so high for so long and what are the implications for the current and future policy arrangements? Andersen and Guomundsson (1998) argue that the main source of inflation during the 1970s and early 1980s was a combination of adverse external shocks and large devaluations that followed. These developments in turn set a price-wage spiral that led to an acceleration in inflation. Agnarsson et al. (1998) argue that the government used the exchange rate to affect the level of prices in order to achieve full employment and that this tool still exists: “It is not difficult to imagine a macroeconomic downturn which is sufficiently large to call for exchange rate adjustments.” That possibility, according to Agnarsson et al. (1998), induced reckless behavior on the part of unions and firms in setting wages, knowing that the exchange rate could always be used to bring about full employment. In fact, econometric studies of the inflation process in Iceland confirm that it is mainly driven by imported inflation and wages (see Andersen and Guðmundsson, 1998, Petursson, 1998, and Chapter 2 of this report).

Figure 1.
Figure 1.

Iceland: Inflation 1970–1998

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A001

Sources: International Monetary Fund, International Financial Statistics.

5. Under the present arrangement, price stability is the focus of monetary policy, with the exchange rate being an intermediate target. According to its statute, the central bank’s aim is to maintain monetary stability and ensure the full and efficient utilization of productive capacity. Monetary stability is interpreted as price and exchange rate stability.

6. The krona has been relatively stable in the years since the adoption of the fixed exchange rate system in 1989. The exchange rate of the krona, defined in terms of a basket of currencies, was allowed to fluctuate within a band. The two devaluations since 1989 were aimed at absorbing external shocks without causing a devaluation-inflation spiral of the type observed in the past. The first devaluation of the currency, by 6 percent, took place in November 1992 following the turmoil in the European currency markets, and the second, by 7.5 percent in June 1993, was in the face of adverse supply shocks in the fishing industry. Between 1993 and 1995 this exchange rate band remained fairly narrow, ± 2.5 percent around a central point, but it was widened in 1995 to ± 6 percent. The exchange rate has remained close to the center of the band after its widening, implying that the credibility of the system remained strong. The widening of the band was intended to limit incentives for speculation against the krona and to provide the authorities with additional flexibility to pursue desired policies.

7. Until December, the basket consisted of 16 currencies and trade shares determined the weight of each currency. The introduction of the euro meant that the basket was adjusted

8. with the weights of the euro area countries combined into one. As a result of this technical adjustment, the euro has become the most important currency in the basket (Box 5 of SM/99/90). If the United Kingdom, Sweden, and Denmark adopt the euro, the euro’s share will rise to just below 60 percent.

B. A Simple Model for a Small Open Economy

9. The following simple model attempts to capture, with a view to motivate the discussion, the current monetary policy framework in Iceland. The ideas embedded in this type of model are standard in the literature (see Barro and Gordon, 1983, and Persson and Tabellini, 1994, and references therein). The main ingredients can be summarized as follows: the authorities dislike exchange rate instability, as indicated by the first quadratic exchange rate term of equation (1), but they also have an incentive to create inflation surprises to reduce the product wage and thus raise output. This second term can be derived from a standard Lucas-supply function where output deviates from the natural rate when π≠πe, implying a short-run tradeoff between inflation and output.

L=−α2Δϵ2+β(π−πe)(1)
ϵ=θϵ1+(1−θ)ϵ2(2)

where L is the objective function of the authorities, ∊ is the official (trade-weighted) exchange rate, π and πe are the actual and expected rates of inflation respectively with the standard inflation surprise term (π-πe). It is further assumed that the official exchange rate index is composed of two currencies ∊1 and ∊2 and the weight θ is determined by trade shares—usually taking into account both imports and exports. For simplicity, equation (3) expresses inflation as a negative function of the official exchange rate index ∊ and a parameter ϒ.

π=−γΔϵ(3)

10. The model presented above illustrates the well-known time-consistency problem: given its preferences and the public’s expectations of “low inflation”, the government has an incentive to raise output above its natural rate. This drives inflation expectations and pushes inflation permanently higher. Given the objective function, which places a weight on output stabilization, and the expectations for inflation, a promise to keep inflation at that low level is time-inconsistent because the authorities have an incentive to, and will, renege upon their announced promise.

11. This is shown as follows: the policymaker chooses ∊ to minimize the loss function. The result is a time-consistent inflation rule, equation (4), and is based on the assumption that expectations of inflation are given, and thus treated as exogenous. In this case the exchange rate will be set as follows:

Δϵ=−βγα(4)

and inflation will be given by:

π*=γ2βα(5)

12. This is equal to the exchange rate depreciation given by equation (4), weighted by the parameter γ of the inflation equation. The government has thus an incentive to create surprise inflation. Although the government keeps the exchange rate fixed, it can nevertheless allow it to depreciate within the band or devalue if it wishes.

13. This simple model raises two policy questions for Iceland, both of which are discussed and analyzed from a “European” or “euro” perspective in the next sections. The first question deals with the intermediate target and the final objective of monetary policy and what constitutes appropriate policy in the light of the adoption of the euro in the EU. Choosing a different exchange rate index will have an effect on the inflation rate but the basic issue of the inflationary and devaluation bias is central to either case. So the second issue deals with the statute of the Central Bank of Iceland. This model suggests that it is best to remove the inflation bias completely by delegating monetary policy to an independent Central Bank, which has price stability as its only objective.2

A peg to the euro?

14. What is implied by a peg to the euro? In terms of the simple model described earlier, suppose that the policy focuses on ∊1 (say the euro) but the inflation equation is unchanged. Then it is easy to show that if

L=−α2Δϵ12+β(π−πe)(6)

then the exchange rate depreciation and inflation rate are given by:

Δϵ1=−βγθα(7)
π^=−γΔϵ=γ2βθ2α−γ(1−θ)Δϵ2(8)

Note that if θ=1, then the second term is zero and inflation is only a function of the parameters in the objective function—which determine the preferences of the policymaker with respect to exchange rate stability and output—and the responsiveness of inflation to changes in the exchange rate. This is the usual inflationary bias term that stems from the fact that the policymaker has an incentive to create surprise inflation, by devaluation in this case, to raise output. The second term, which is a function of ∊2, is important in this model. It is a result of the composite exchange rate index: an appreciating ∊2 (Δ∊2>0) implies that inflation will be even smaller. So when θ<1, the variance of the inflation rate will be larger. Note however that the inflation-bias term is reduced slightly, by θ2, since a fall in ∊1 will have a less inflationary impact than a fall in ∊. Consequently, the effect on inflation is not clear-cut although the expected variance will be higher.

15. Trade shares (Table 1) show that the bulk of the trade, about 68 percent of the total, is conducted with the European Economic Area (EEA). However, only about 31 percent of total trade is carried out with the euro-11 area. Given the close trade links between the United Kingdom and Iceland, that share rises to 45.5 percent when the United Kingdom is included in the euro area. Hence, the Icelandic authorities have concluded that a closer link with the euro should be considered only if a wider EMU were to emerge, comprising the United Kingdom and perhaps Denmark and Sweden. Indeed, this conclusion seems to be consistent with the objective of minimizing the variance of the official index. However if one takes into account of Norway and other European countries that maintain exchange rate pegs to the euro, this (implied share of the euro) rises to more than 50 percent, (if one adds Denmark it is closer to 60 percent) even without adding the UK. Thus a peg to the euro would certainly also imply considerable exchange rate stability.

Table 1:

Foreign Trade by countries

(percentage share)

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Equal to the average of exports and imports

Euro 12 includes the UK, while euro 14 includes, in addition, Denmark and Sweden

16. However, the key argument in favor of a euro peg is based on the credibility of the system and its effect on inflation expectations. A (single) currency peg to a low-inflation currency, the euro in this case, is transparent and provides a clear anchor for inflation expectations. Given that the European Central Bank (ECB) is likely to acquire considerable credibility, a peg to the euro would enhance the credibility of the anti-inflation policy. The inflation bias, illustrated with the aid of the simple model, will be minimized as any scope for discretionary policy is greatly reduced.

A bilateral agreement with the ECB?

17. The debate in Iceland has also considered the possibility of a bilateral exchange rate agreement with the ECB. Under such an agreement, the ECB would provide liquidity support for the agreed exchange rate peg. Article 109 of the Maastricht Treaty specifies that “…the Council may, acting unanimously on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavor to reach a consensus consistent with the objective of price stability, after consulting the European Parliament… conclude formal agreements on an exchange rate system for the ECU in relation to non Community currencies.” Thus, the treaty makes it clear that bilateral arrangements with non-EU countries are possible. However, such arrangements must be “approved” by the ECB. It is considered unlikely that such an arrangement could be reached while Iceland remains outside the EU. Moreover, if it is perceived that a bilateral agreement with Iceland might inhibit the ECB’s ability to pursue its goals effectively, an ERM II-type agreement between Iceland and the EU is unlikely to materialize.

Business cycle synchronization

18. The traditional prerequisite for closer integration with the euro area, either through membership or exchange rate coordination, is sufficient synchronization with the business cycles of the euro area. The available empirical evidence suggests that Iceland’s business cycles have not been very synchronized with those in the Euroland (Figure 2)—and have been more volatile (see Agnarsson et al., 1998, and Central Bank of Iceland, 1997). Table 2 shows that very little of the variation in GDP growth, terms of trade, and export growth can be explained by the variation of these quantities in a “narrow euro area,” consisting of Germany, France, the Netherlands, Luxembourg, Belgium, Finland, Ireland, and Austria. It also shows that the variance of GDP growth in Iceland is the highest compared with this group. Table 3 shows the simple correlations of a number of variables. In fact, a number of studies suggest that most recessions in Iceland during the last 40 years can be explained to a large extent by price and demand developments in major export markets (see Table 4). Only few recessions were propagated by domestic shocks, including fluctuations in the fish catch (see Agnarsson et al., 1998, and references therein).

Figure 2.
Figure 2.

GDP growth

Citation: IMF Staff Country Reports 1999, 068; 10.5089/9781451819212.002.A001

Table 2.

Iceland: Symmetry of Business Cycles with Respect to a Narrow EMU Area 1961–1995

(In percent)

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Source: Central Bank of IcelandNote: Narrow EMU is defined as: Germany, France, Netherlands, Luxembourg, Belgium, Finland, Ireland and Austria. The total variation of a single economic variable is measured in terms of its standard deviation. The symmetric part of the total variation is the ratio of the standard deviation of the relevant economic variable that can be explained by variation in the EMU area, estimated by R2 of the regression of the relevant vartianble on the corresponding variable for the EMU area.
Table 3.

Iceland: Correlation with Respect to EMU Area 1970–1995

(In percent)

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Source: Central Bank of Iceland.
Table 4.

Iceland: External Shocks 1963–1997

(Fall in export revenue exceeding 2 percent)

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Source: Central Bank of Iceland

19. The lack of synchronization would suggest that there would be a cost associated with a peg to the euro, or EMU membership, since monetary policy would be determined by the ECB based on economic conditions in the Euroland as a whole. Indeed, the idiosyncratic business cycle in Iceland and the frequency of supply shocks argue for a flexible exchange rate. It should be noted, however, that monetary independence and exchange rate flexibility in the 1970s and 1980s did not diminish Iceland’s business cycle fluctuations.

C. Central Bank Independence

The case for independence

20. Full independence for the Central Bank of Iceland and the announcement of a statutory objective of price stability would maximize the benefits of a currency peg to the euro, EU membership or inflation targeting. The formal model suggests that the presence of the second term in the objective function creates an inflation bias, which can be eliminated by setting β=0. This can be achieved by delegating monetary policy to a fully independent central bank with preferences (statutes) that specify price stability as the only policy objective.

21. Moreover, closer links with the EU, either through an exchange fate arrangement in an initial stage or full participation in the EU, requires countries to have an independent central bank prior to entry. Given that the Statute of the ECB envisages a very important role for the governors of the National Central Banks (NCBs)—they are members of the ECB’s Governing council—in the formulation of monetary policy, it is a precondition for NCBs to be independent prior to adopting the euro. For this reason it was considered very important that the national legislation, including the statutes of the NCBs, be compatible with the Treaty and the Statute, the so-called legal convergence. According to the convergence report prepared by the European Monetary Institute (EMI) in March 1998 (page 12) “Central Bank independence is essential for the credibility of the move to Monetary Union and, thus, a prerequisite of Monetary Union”.

22. This chapter distinguishes between political and economic independence (Grilli et al., 1991). Political independence is defined as the ability of a central bank to make decisions which are not influenced or sanctioned in anyway by the government. The first element is a guarantee of a lengthy term in office for the governor and the board of directors. This eliminates or minimizes the involvement of the government in the appointment of the management of a central bank. In addition, it is important that no government official be involved in the monetary policy decision making process and no government approval is required for decisions regarding monetary policy. Finally, a statutory requirement that the central bank pursue monetary (preferably price) stability, amongst its goals, is an important element of political independence. Economic independence refers to the ability of a central bank to use, without restrictions, monetary policy instruments in order to achieve specific goals. More specifically, the central bank has instrument independence and is not constrained in any way, in pursuing its policies, by any obligation to finance public deficits.

23. It is useful to compare in terms of these institutional characteristics the Central Bank of Iceland with those in other European countries and the ECB. Tables 5 and 6 list a number of these factors that determine the degree of political and economic independence for Iceland, the ECB, and other countries. All these characteristics refer to the statutes of the central banks and not to actual practice in each country.

Table 5.

Political Independence

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Governor not appointed by the government.

Governor appointed for more than 5 years.

All board not appointed by the government.

All board appointed for more than 5 years.

No mandatory participation of government representative in the board.

Statutory requirements that Central Bank pursues monetary stability amongst its goals.

Legal requirements that strengthen the Central Bank’s position in conflicts with the government are present.

Sum of 1–7

Iceland: 1–4. The 3-member Board of Governors, which determines monetary policy, is appointed by the Minister of Commerce.Source: Grilli, Masciandaro and Tabellini (1991); other sources include national Central Banks
Table 6:

Economic Independence

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Direct credit facility: not automatic.

Direct credit facility: market interest rate.

Direct credit facility: temporary.

Direct credit facility: limited amount.

Central Bank does not participate in primary market for public debt.

Instrument Independence.

Banking supervision not entrusted to the Central Bank (**) or Banking supervision not entrusted to the Central Bank alone (*).

Sum of 1–7

Source: Grilli, Masciandaro and Tabellini (1991); other sources include national Central Banks

The European Central Bank (ECB)

24. According to Article 2, the ECB “[…] when exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty and this Statute, neither the ECB, nor a national central bank, nor any member of their decision making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body. The Community institutions and bodies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision making bodies of the ECB or of the national central banks in the performance of their tasks.”

25. The Statute of the ECB and the Maastricht Treaty make it clear that “[…] the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community […]” (Article 2). To support these objectives, the Statute does not allow any overdraft facilities or any other type of credit facility with the ECB or with the NCBs. They also provide for instrument and goal independence and shield the bank from any political pressure stemming from the European or national level.

26. Given the complexity of the European System of Central Banks (ESCB), the Statute also makes it virtually impossible for the NCBs to exert any pressure stemming from the political establishment in each country. Article 14 states that “[…] each Member State shall ensure, at the latest at the date of the establishment of the ESCB, that its national legislation, including the statutes of its national central bank, is compatible with this Treaty and this Statute […] The statutes of the national central banks shall, in particular, provide that the term of office of a Governor of a national central bank shall be no less than five years. A Governor may be relieved from office only if he no longer fulfils the conditions required for the performance of his duties or if he has been guilty of serious misconduct. A decision to this effect may be referred to the Court of Justice by the Governor concerned or the Governing Council on grounds of infringement of this Treaty or of any rule of law relating to its application […]”.

27. Since this was drafted in the early 1990s, a number of Central Banks in the EU have revised their statutes after having been granted independence by their governments. Two important examples are the Central Banks of the United Kingdom and Sweden. Tables 5 and 6 suggest that the Central Bank of Sweden and the ECB have the highest scores in terms of political and economic independence.

The Central Bank of Iceland

28. The Central Bank of Iceland appears to lag behind these countries in a number of ways. First, it seems politically less independent if compared with a number of countries, including the ECB. The main weaknesses arise from the role of the government in appointing the Board of Governors. Article 4 of the Statute of the Central Bank of Iceland states that “The Central Bank shall in all its activities maintain close co-operation with the Government and present to the Government, its views on policy in economic affairs and the implementation thereof. In the event of significant disagreement with the Government the Board of Governors of the Central Bank may state so publicly and explain its views. It shall nevertheless, consider it as one of its main objectives to endeavor to implement such policy as the Government ultimately laid down.” Moreover, although the Statute states that the central bank pursues monetary stability among its goals, price stability is not explicitly mentioned. In terms of economic independence, the two important issues are the overdraft facility to the Treasury which is permitted by the statutes — although this is closed after an agreement with the Treasury — and instrument independence of the Bank.3 As regards the latter, the extract from the Statute indicates that since the government sets the goals and requires the Bank to act according to these goals, the government can, if it wishes, stop the Central Bank from independently changing monetary policy. Thus, in the event of a disagreement between the Central Bank and the government, the latter’s opinion would prevail.

D. A Case for Inflation Targeting

29. Exchange rate targeting has the advantage of providing a clear anchor for exchange rate expectations in stabilizing the prices of traded goods. However, a fixed exchange rate system should also lead to wage moderation so as to ensure price stability and maintenance of competitiveness. If this is not the case, the peg will eventually be abandoned. Real exchange rate variability may be exacerbated if Iceland’s business cycle becomes less synchronized with its partners. Therefore, close integration with the main trade-partners is essential to maintain a successful peg.

30. It is well known that several countries—among them New Zealand, the United Kingdom, Canada, Sweden—adopted inflation targeting in recent years. In some cases, this can reflect a disillusionment with monetary targeting, as money demand functions became unstable in the face of widespread financial innovation and the relationship between the central bank’s policy instrument, a discount rate or short-term interest rate of some kind, and the price level or rate of inflation became unreliable, undermining the basis for the strategy. In other cases, where an exchange rate target had already been embraced for some of the same reasons, speculative crises in the foreign exchange markets undermined the ability of the central banks concerned to stick to the strategy, notably in the case of the ERM crisis of 1992 and the crises affecting the Scandinavian currencies in the same year.

31. The experience of countries that have adopted inflation targeting—though not of long standing—has been reviewed in Leiderman and Svensson (1995) and Haldane (1995). In terms of the relationship of the strategy to the declared ultimate objective of price stability, inflation targeting appears to be logical. Inflation targeting may have a drawback as compared with monetary targeting in that it cannot be monitored so readily. If monitoring of the inflation strategy is interpreted as involving a comparison of inflation realizations with the pre-announced target, then the lags in impact of policy indeed make this so (see Cukierman, 1996, for a model of this type). However, if inflation-forecast targeting is the stated policy, this problem disappears (Svensson, 1999a, for example).

32. Inflation targeting involves: (1) an explicit quantitative inflation target, (2) a framework for policy decisions and an institutional commitment to price stability, and (3) a high degree of transparency and accountability. “Flexible” inflation targeting (FIT) gives some weight to output variability in the economy and it involves (in technical terms) minimization of an (intertemporal) loss function represented by:

Lt=12[(πt−πt*)2+λyt2]

where π* is the inflation forecast and γ is the output gap. With “strict” inflation targeting (SIT), λ is set equal to zero. Under these circumstances, such a loss function implies that the conditional inflation forecast becomes the intermediate target at an appropriate time horizon (say 18–24 months, depending on the country and the transmission mechanism). Additionally, FIT implies a more gradual adjustment toward the inflation target. The central bank’s role is to compute conditional forecasts for inflation and the output gap and to set its policy instrument so that the target is achieved. To enhance clarity and communication with the public, many countries publish inflation reports with forecasts of inflation and other important information.

33. For a small open economy like Iceland, the exchange rate is a very important channel for the transmission mechanism of monetary policy. As discussed earlier, the exchange rate affects import prices directly and almost instantaneously and consequently affects the CPI. It also affects aggregate demand with a lag, and output and the CPI through second round effects. On the supply side, there are also very short-term effects on production costs and longer term effects through wages. However, the exchange rate is influenced by exogenous disturbances, among other things, and the credibility of the inflation targeting regime. Since the exchange rate contributes to absorbing foreign disturbances, it has a stabilizing effect on the CPI. According to Svensson (1999b), the FIT regime provides considerable exchange rate stabilization compared with the SIT regime. Under SIT, the loss function is minimized when the CPI is stabilized at a very short horizon. Since it is the exchange rate that has a sizable impact on inflation at very short horizons, SIT relies on exchange rate movements to stabilize inflation. This results in higher variability in the exchange rate and output. In contrast, placing some weight on output under FIT implies targeting inflation at longer lags and allows greater stabilization of the exchange rate. In addition, under FIT some weight can be placed on exchange rate stability as well:

Lt=12[(πt−πt*)2+λyt2+λqqt2)]

where qt could be the deviation of the real exchange rate from equilibrium or desired level. Abstracting from any implementation problems that this approach may have it could lead to some stabilization of the exchange rate.

34. In the event of adopting an inflation target, a number of the institutional changes will have to be made as described above. In addition, the Central Bank of Iceland must begin publishing, on a regular basis, inflation forecasts for longer horizons than it does now (12 months ahead - see Autumn Statement of the Central Bank of Iceland, 1998) and explain these projections. Publication of an inflation report, along the lines of those published by the Bank of England and the Central Bank of Sweden, would enhance the credibility of the system.

Conclusions

35. The main focus of this chapter is on the appropriateness of Iceland’s current exchange rate regime in the light of the adoption of the euro by 11 European Union (EU) countries and the possible enlargement of the euro area to include the United Kingdom, Denmark, and Sweden. Over the medium term, a decision will have to made whether to move closer to the EU, by focusing on monetary developments in the euro area, or, whether to continue with the existing exchange rate arrangement. Any decision will inevitably have to balance the need for acquiring and maintaining credibility in pursuing monetary policy goals, against the desirability of maintaining flexibility to deal with external shocks.

36. The present monetary framework has acquired considerable credibility in recent years but has not been fully tested yet. Following the unstable economic environment of the 1980s, the recent period of financial stability has helped to change attitudes, but institutions of policy-making may also need to be adapted in the future to meet the challenges of a shifting external environment. In terms of an exchange rate peg, there are two realistic options for Iceland: continue with the existing framework or adopt a unilateral peg to the euro. There is also the option of adopting an inflation target. It is argued that all of these alternatives would entail greater and formal independence for the central bank, something which will probably require reforming the Central Bank of Iceland Act. In addition, it is argued that the objective of monetary policy has to be clearly defined and included in the legislation.

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1

Prepared by Zenon Kontolemis.

2

More precisely, it is stability of inflation at a low level. Price stability would require a large deflation to follow a large positive price shock.

3

The overdraft facility was closed recently after an agreement between the Treasury and the Central Bank. According to the statutes however “The Central Bank shall act as banker to the Treasury…[and]… may advance short-term loans to the Treasury” (Article 10).

Same Series

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Cover IMF Staff Country Reports
Iceland: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1999: Issue 068
Publisher:
International Monetary Fund
ISBN:
9781451819212
ISSN:
1934-7685
Pages:
146
DOI:
https://doi.org/10.5089/9781451819212.002

Iceland: Inflation 1970–1998

GDP growth