Iceland Crises

Business Administration (BScB) + (IM)

Authors: Ellert Jón Björnsson Kristinn Thor Valtýsson Advisor: Roger Bandick

Financial Crisis in Iceland
Icelandic Monetary Policy

Aarhus School of Business December 2009

Abstract
From being one of the poorest nations in Europe to becoming one of the most successful economies in the West, the geographically isolated country of Iceland suffered a lot when its three major banks collapsed in the same week in October 2008. As a consequence of the banking crisis, Iceland entered a deep recession and deep cuts in employment were made and the exchange rate dropped sharply which caused the inflation to soar. The Central Bank of Iceland has been criticized for its monetary policy in the past and how it handled the collapse. This thesis is intended to examine the monetary policy in Iceland and how the Central Bank handled the collapse and to look into the causes that made the financial crisis to be so severe.

Keywords: Iceland, Financial Crisis, Monetary Policy, Central Bank, Inflation.

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Table of Contents
1.0 Introduction .............................................................................................................. 6 2.0 Theoretical Framework ............................................................................................ 8 2.1 Quantity Theory of Money .................................................................................. 9 2.2 IS-LM Relation .................................................................................................. 10 2.3 AS-AD Relation ................................................................................................. 12 2.4 Extension of IS-LM Relation ............................................................................. 14 2.5 Phillips Curve..................................................................................................... 15 2.6 Marshall-Lerner Condition - Interest Parity Condition ..................................... 17 2.7 Net Capital Outflow ........................................................................................... 18 2.8 Exchange Rate ................................................................................................... 20 3.0 Central Bank‟s Actions and Policies...................................................................... 21 3.1 Importance of the Independence of the Central Bank ....................................... 21 3.2 Policy Instruments ............................................................................................. 22 3.2.1 Open Market Operations ............................................................................. 23 3.2.2 Interest Rate ................................................................................................ 23 3.2.3 Reserve Requirements ................................................................................ 24 3.2.4 Foreign Exchange Market Intervention ...................................................... 25 3.3 Goals of the Central Bank .................................................................................. 25 3.4 Inflation .............................................................................................................. 26 3.5 Exchange Rate ................................................................................................... 27 3.5.1 Balance of payments ................................................................................... 28 3.6 Monetary Tools in Action .................................................................................. 29 4.0 The Objectives and Roles of the Central Bank of Iceland ..................................... 30 4.1 Interest Rate ....................................................................................................... 31 4.2 Inflation in Iceland ............................................................................................. 31 4.3 Relation Between Inflation and Interest Rates................................................... 33 4.3.1 Abolition of Reserve Requirements ............................................................ 35 4.4 Exchange Rate ................................................................................................... 35 4.4.1 The History of the Icelandic Krona ............................................................ 35 4.4.2 Historical Exchange Rate of the Icelandic Krona ....................................... 36 4.4.3 Balance of Payments in Iceland .................................................................. 37 4.4.4 Foreign Exchange Reserves ........................................................................ 38 5.0 Collapse of the Icelandic Financial System ........................................................... 39 5.1 A Systemic Crisis ............................................................................................... 40 5.2 How Did the Central Bank of Iceland Handle The Collapse? ........................... 42

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5.3 Carry Trade and Central Bank Dilemma ........................................................... 44 5.4 Philips Curve in Iceland ..................................................................................... 47 6.0 Economic Recovery ............................................................................................... 48 6.1 The International Monetary Fund Agreement ................................................... 50 6.2 Capital Controls ................................................................................................. 51 7.0 The Future Prospects of the Icelandic Economy ................................................... 53 7.1 If Iceland Were to Become a Member of the EU .............................................. 55 7.2 Economic Forecasts ........................................................................................... 57 8.0 Conclusion ............................................................................................................. 59 References .................................................................................................................... 62 Appendix ...................................................................................................................... 70

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Figure Overview
Figure 1: Quantity Theory of Money ............................................................................. 9 Figure 2: IS-LM Relation............................................................................................. 11 Figure 3: AS-AD Relation ........................................................................................... 13 Figure 4: Extension of IS-LM Relation ....................................................................... 15 Figure 5: Phillips Curve ............................................................................................... 16 Figure 6: The Effect of Capital Flight.......................................................................... 19 Figure 7: Historical Inflation in Iceland....................................................................... 32 Figure 8: Relation Between Inflation and Interest Rate............................................... 34 Figure 9: Exchange of the Icelandic Krona ................................................................. 37 Figure 10: Balance on Current Account ...................................................................... 38 Figure 11: External Debt to GDP-Ratio....................................................................... 46 Figure 12: Phillips Curve in Iceland 1990-2008 .......................................................... 47 Figure 13: Outstanding Debts of Households and Firms ............................................. 49 Figure 14: External Debt, 2008 (Percent of GDP) ....................................................... 51

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1.0 Introduction
Iceland went from being one of the poorest nations in Europe to becoming one of the most successful economies in the West. This was underlined when Iceland was judged the best place to live in the world by the United Nations in November 2007 (Pierce 2008). After a period of prosperity Iceland suffered a lot when its three major banks collapsed in the same week in October 2008. The collapse is related to the global financial crisis, but it seems the recession will be deeper in Iceland than in other European countries. In the OECD Economic Survey on Iceland it is stated: “It appears that the Icelandic financial supervisory authorities had become overwhelmed by the complexity of the national banking system, and had been unable to stop their expansion. By the end, the size of the banks far exceeded the limited capacity of the Icelandic authorities to rescue them.” (OECD 2009: 9). As a consequence of the crisis, Iceland entered a deep recession and deep cuts in employment and working time were made. Unemployment rate rose from 2.5 percent in the third quarter of 2008 to 7.1 percent by the first quarter of 2009. There was also a sharp drop in the exchange rate of the Icelandic krona (ISK), which caused inflation to soar, although it had slowed to 11.6 percent by May 2009. Wages adjusted quickly to the crisis, falling by 6.75 percent in real terms in the year to April 2009. The projected unemployment rate is expected to rise to a peak of 10 percent in 2010 while inflation should fall to around 2.5 percent (OECD 2009). Iceland is now moving towards economic recovery with multilateral assistance from the International Monetary Fund (IMF). The Icelandic banking sector had big impact on the economy when it was deregulated and privatized in the 1990s and early 2000s. At that time, the newly privatized banks had easy access to foreign capital at a low cost. The banking sector grew enormously after the privatization. The balance sheet of the three largest banks was nine-fold the country‟s annual GDP at the end of 2007, a big change from year 2004 when they were roughly equal to one year‟s GDP. This expansion was almost entirely driven by foreign borrowing (Danielsson & Zoega 2009a). At the end of July 2008, the size of the banking sector‟s debt was 850 percent of the national GDP and 73 percent of the debt was foreign (Euroweek 2008).

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The monetary policy in Iceland also contributed to the crisis. Since inflation targeting was adopted in 2001, which failed in lowering inflation, the interest rate has been rising. The high interest rate motivated households and firms to borrow in foreign currency and attracted foreign carry traders. The inflow of foreign capital is not publicly known, but it appears to have exceeded 50 percent of GDP, and it is unclear why this did not raise concerns with the authorities (Danielsson & Zoega 2009a). Iceland‟s external liabilities swamped the Central Bank‟s ability to act as lender of last resort. The Icelandic economy was hit hard by the financial crisis when its three major banks collapsed in the same week in October 2008. The Central Bank of Iceland has been criticized for its monetary policy and how it handled the collapse. This critic attracted the attention of the authors of this thesis and therefore it is relevant to examine the monetary policy in Iceland and how the Central Bank handled the collapse. We also felt it was of interest to try to understand causes and consequences of changes in the quantity of money in the economy. The authors seek to answer the following questions in this thesis:    What efforts has the Central Bank of Iceland made to promote price- and financial stability? How did the Central Bank of Iceland handle the collapse? What caused the financial crisis to be so severe in Iceland?

The development of the Icelandic financial system has reflected the political and economic evolution of the country from a poor dependency of the Danish Crown into a modern high-income republic. The first Icelandic bank, Landsbanki Íslands (National Bank of Iceland), was established in 1885 and it received as capital a small issue of treasury notes, which were freely convertible into Danish crowns. After World War I, monetary policy was not an active part in the management of the Icelandic economy and Landsbanki had the sole right to issue notes since 1927. In 1957 a note-issue department was given separate management and in 1961, the fully autonomous, Central Bank of Iceland was created out of Landsbanki´s central banking department. Traditional central banking functions, including the sole right to

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issue notes and coins and manage the foreign exchange reserves, was assigned to the Central Bank, and it acted as a banker to the government and was for a period allowed to grant short-term credit to the Treasury. The Central Bank was also given power to regulate interest rates and also to influence the liquidity of the banking system through short-term lending and by requiring the banks to hold blocked reserves with the Central Bank. Although the Central Bank was formally independent, it was required by law to support the economic policy of the government which means that it could not make major changes in, for example, interest rates or reserve requirements, if these were objected by the government. In 1984 a radical change in the monetary policy took place, when the first steps were taken to deregulate interest rates. In 1986, when the Central Bank Act was revised, the Bank‟s powers to regulate the interest rates of commercial banks and saving banks were abolished (Central Bank of Iceland 2002a). This thesis will put emphasis on roles and objectives of central banks. The thesis starts by explaining the major macroeconomic theories, which are relevant for this topic. The thesis goes further on clarifying the roles and objectives of central banks in general, and how they use their monetary tools to keep the economy stable. Consequently, actions of the Central Bank of Iceland will be discussed and related to the theories. Then the collapse of the Icelandic financial system in October 2008 will be discussed and related to the actions of the Central Bank. Furthermore, the authors discuss efforts made in the economic recovery and the future prospects of the Icelandic economy. In the end there will be a conclusion, which will act as a summary of our findings.

2.0 Theoretical Framework
The following chapter will introduce some basic macroeconomic theories that are suitable for the research topic in attempt to understand the causes and consequences of short-run and medium-run fluctuations in the national economy. The theories will be briefly explained and simplified to make it easier to relate them to the subject of Icelandic monetary policy.

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2.1 Quantity Theory of Money
The amount of money available in an economy is controlled by the central bank and is called money supply. In practice, central banks use open market operations; purchase and sell government bonds from the public, to increase or decrease the amount of money in circulation in the economy. The demand for money depends on the sum of monetary assets, such as cash and bank and other cheque accounts that people want to hold in their portfolios (Abel, Bernanke, McNabb 1998). Alfred Marshall and Irving Fisher formalized the quantity theory of money nearly a hundred years ago. “The quantity theory of money predicts that an increase in the supply of money will cause a proportional increase in the price level.” (Gwartney, Macpherson, Sobel, Stroup 2006: 311). The quantity theory of money describes that if there is a permanent increase in nominal money growth of, say, 10 percent, it is eventually reflected in a 10 percent increase in the inflation rate and a 10 percent increase in the nominal interest rate – leaving the real interest rate 1unchanged. The result that, in the medium-run, the nominal interest rate increases one for one with inflation is known as the Fisher effect, after Irving Fisher (Blanchard 2006). In Figure 1 it can be seen how the interest rate is determined, where the money supply and the money demand is in equilibrium. Figure 1: Quantity Theory of Money

Source: Blanchard 2006.

1

Interest rates expressed in terms of a basket of goods is called real interest rates (Blanchard 2006).

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The negative slope of the money demand curve reflects the effect of the opportunity cost of holding money, given the level of economic activity and the cost of converting funds. If we assume that the real GDP2 and transaction costs are to remain unaffected, the demand curve does not shift. An increase in the real money supply3 lowers the nominal interest rate and a decline in interest rate induces a higher demand to match the higher supply. This is a good example to illustrate the power of a central bank to influence the interest rates. The demand curve can shift when there is a change in real GDP, for example if the real GDP increases the money demand will increase as well and the demand curve will shift to the right. If the real money supply stays the same, the interest rate must rise until the increased demand is entirely offset by the higher opportunity cost of holding money. This is why interest rates are often pro-cyclical, rising in booms and declining in recessions (Burda & Wyplosz 1997).

2.2 IS-LM Relation
A nation‟s economic performance depends heavily on macroeconomic policies. The two major types of macroeconomic policies are fiscal policy and monetary policy. Abel, Bernanke and McNabb describe macroeconomic policies in their book Macroeconomics as following: “Fiscal policy, which is determined at the national and local levels, concerns governments spending and taxation. Monetary policy affects short term interest rate and rate of growth of a nation’s money supply and is under the control of a government institution known as the central bank.” (Abel et al. 1998: 12-13). The IS-LM model shows the relation between these two policies and how they may influence each other, but it is important to keep in mind that they may not be independent of each other. The model has been widely applied in analyses of cyclical fluctuations and macroeconomic policy, and in forecasting. To explain the fundamentals of the IS-LM relation in the simplest way, we assume that the economy is closed (Abel et al. 1998).

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Real GDP is constructed as the sum of the quantities produced in an economy times constant price in a base year (Blanchard 2006). 3 Real money supply is money in terms of goods, M/P (Blanchard 2006).

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Figure 2: IS-LM Relation

Source: Blanchard 2006. Along the IS curve, the goods market is in equilibrium, and along the LM curve the money market is in equilibrium; therefore, for both markets to be in equilibrium, the system must be on both curves, which only occurs at the intersection of the curves. The LM curve shows the relationship between the real interest rate and the level of output that arises in the market for real money balance. The LM curve is drawn for a given supply of real money balances and is upward sloping because higher output raises money demand, and therefore raises the real interest that clears the asset market. Decrease in the supply of real money balances shifts the LM curve upward, which leads to a higher interest rate that stimulates savings. On the other hand, increase in the supply of real money balances shifts the LM curve downward which leads to a lower interest rate which stimulates investments. Blanchard made the assumption that people and firms do not revise their expectations of inflation immediately, which means that the IS curve does not shift. Instead the economy moves down the IS curve and the equilibrium moves from Y1 to Y3 as illustrated on Figure 2. This results in higher output and lower nominal interest rate (Mankiw 1997; Abel et al. 1998; Blanchard 2006). The IS curve shows the relationship between the interest rate and the level of output that arises from the market for goods and services. The IS curve is drawn for a given fiscal policy and is downward sloping because higher output raises savings, and leads to a lower market-clearing interest rate. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right which leads to expansion in the economy. Changes in fiscal policy that reduce the demand for goods and service shift

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the IS curve to the left which leads to contraction in the economy (Mankiw 1997; Abel et al. 1998). Although the IS-LM model is a fundamental model in macroeconomics it has its limitations. If the model is meant as long-run, then its prediction that equilibrium can exist at any level of output is very controversial. If the model is used as a short-run model it is also severely limited because it does not incorporate the rate of expected inflation because expected inflation creates a difference between real and nominal interest rates. Although this model has serious weaknesses, there is no other model that gives as much insight in macroeconomic thinking (Schenk 2007). The IS-LM model for an open economy is similar to the model for a closed economy. The main difference is that in the open economy IS-LM model, factors (other than output or the real interest rate) that increase a country‟s net export cause the IS curve to shift up. Economic shocks and policy changes are transmitted from one country to another by changes in the net exports, which lead to IS curve shifts. If we assume that a floating exchange rate regime is in use, it would indicate that the domestic interest rate must be equal to the world real interest rate, where the interest rate is helping to equilibrate the goods market and the money market (Abel et al. 1998).

2.3 AS-AD Relation
Another perspective on analysis of the effects of various shocks on the economy is to use the aggregated supply-aggregated demand (AS-AD) model. The IS-LM model shows the relation between real interest rates to output, but the AD-AS model relates the price level to output. Although the choice of the IS-LM framework or the AD-AS framework is a matter of convenience, the two models express the same basic macroeconomic theory. The aggregate supply curve shows the relation between the price level and the aggregate amount of output that firms supply. Blanchard assumes that when the AD curve shifts to the right, both output and price level will increase in the short-run. In the medium-run, when the adjustments of price expectations come into play, as output is higher than natural level of output, the price level is higher than wage setters expected. When the wage setters revise their expectations, the AS curve shifts up over time and stops when output has returned to natural level. The aggregate

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demand curve slopes downward because an increase in the price level reduces the aggregate quantity of output demanded (Blanchard 2006). Figure 3 illustrates how a monetary expansion leads to a shift in the AD curve and increases output in the shortrun but has no effect on output in the medium-run because the AS curve shifts upwards until output reaches its natural level. Figure 3: AS-AD Relation

Source: Blanchard 2006.

Outputs in economies are constantly changing, and where any factor that changes the aggregate demand for output will cause the AD curve to shift, Olivier Blanchard goes through four underlying steps to explain the relation between output and price level. The first step is that, when there is an increase in output, e.g. tax reduction, it will lead to an increase in employment because the demand for workers will rise with growing output. The second step is that increase in employment leads to decrease in unemployment and, therefore, to a decrease in the unemployment rate. The third step is that due to lower unemployment rates, the wage setters are not in as good position to negotiate lower wages because workers can go elsewhere while looking for better wages. This leads to higher nominal wages. The fourth step is that when nominal wages have increased, the price level will increase as well. With higher nominal wages the purchasing power parity will grow and therefore consumption will increase which leads to further increase in price level (Blanchard 2006).

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The AS-AD model draws a good picture of a shock on the economy, and because the AS-AD framework is useful in describing the relationship between output and inflation, this model is relevant for this thesis.

2.4 Extension of IS-LM Relation4
In the IS-LM relation an assumption was made that the expected inflation was constant – that there was no expected inflation. It was also assumed that if output was below its natural level, a decrease in price level would adjust the output back to its natural level. The decrease in price level leads to an increase in the real money balance, as explained in the AS-AD relation. This tends to shift the LM curve down, which leads to an increase in output. However, if expected inflation is taken into account, we have a second effect at work. For a given nominal interest rate a decrease in inflation leads to a decrease in expected inflation that would lead to a higher real interest rate. Higher real interest rate induces savings and in turn lower spending which means output will decrease. This results in the IS curve to shift to the left5 due to lower expected inflation. If only the IS curve shifted, the economy would go from A to B´. As a result of these two shifts, it is hard to predict whether output will go up or down; it depends on which shift dominates. In Figure 4, Y´´ is smaller than Y which means rather than returning to its natural level, output declines further away from it. This means that things get worse rather than better.

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This section is based on literature from Blanchard (2006). All leftward shifts in IS curve cause recession.

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Figure 4: Extension of IS-LM Relation

Source: Blanchard 2006.

The scenario in Figure 4 describes that the decrease in output Y to Y´´ leads to a further decrease in inflation and, so, to a further decrease in expected inflation. The decrease in inflation leads to a further increase in the real interest rate, which further decreases output, and so on. When the output continues to decline rather than returning to the natural level of output, the initial recession can turn into a full-fledged depression.

2.5 Phillips Curve
In the 1950s A. W. Phillips analyzed the relationship between inflation and output (actual wage inflation and unemployment rates). Phillips demonstrated that unemployment rates are related to wage inflation. His work was entirely empirical, but it had substantial impact on Keynesian economists since it provided a framework for dealing with inflation (Wachtel 1989). The short-run relationship between inflation and unemployment is therefore often called the Phillips curve.

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Figure 5: Phillips Curve

Source: Michelen 2006.

Blanchard explains how the unemployment rate affects the price level: “Given the expected price level, which workers simply take to be last year’s price level, lower unemployment leads to a higher nominal wage. A higher nominal wage leads to a higher price level. Putting the steps together, lower unemployment leads to a higher price level this year relative to last year’s price level – that is, to higher inflation.” (Blanchard 2006: 168). The negative relation between inflation and unemployment, in short-run, can be explained by changes in production. Mankiw explained how the model of aggregate supply and aggregate demand provides an easy explanation for the menu of possible outcomes by the Phillips curve. “The Phillips curve simply shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.” (Mankiw 2003: 763). As explained earlier, an increase in aggregate demand for goods and service leads, in the short-run, to a larger output of goods and services and a higher price level. As a result of the increase in output, the employment becomes greater, and therefore lowers the unemployment rate. Whatever the previous year‟s price level happens to be, the higher the price level in the current year, the higher rate of inflation. Thus, shifts in aggregate demand push inflation and unemployment in opposite directions in the short-run; this relationship is illustrated by the Phillips curve in Figure 5. Monetary and fiscal policy can shift the aggregate-demand curve, and therefore monetary and

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fiscal policy can move the economy along the Phillips curve. In a way, the Phillips curve offers policymakers a menu of combination of inflation and unemployment (Mankiw 2003). A shift in aggregate supply is associated with a similar shift in the short-run Phillips curve. Shift in aggregate supply leads to higher unemployment and higher inflation, and this will lead to the short-run tradeoff between inflation and unemployment shifting to the right. There is a question of whether the shift in the Phillips curve is temporary or permanent, which depends on how people adjust their expectations of inflation. If people view the rise in inflation as being due to the supply shock of a temporary aberration, expected inflation does not change, and the Phillips curve will soon revert to its former position. On the other hand, if people believe the shock will lead to a new era of higher inflation, then expected inflation rises, and the Phillips curve remains at its new, less desirable position (Mankiw 2003). The Phillips curve is very helpful to illustrate the trade-off between unemployment and inflation, and is therefore relevant to the research topic because in Iceland there has been low unemployment in the past, and in historical context the inflation has been relatively high.

2.6 Marshall-Lerner Condition - Interest Parity Condition
Changes in trade balances are fundamentally dynamic phenomena. The MarshallLerner condition contains the impact analysis of trade changes in response to an instantaneous change in the exchange rate. The condition says that real depreciation in the exchange rate will have positive effect in trade balance i.e. export increases because foreign demand for domestic goods will increase and domestic goods will become relatively less expensive for foreigners. At the same time import will decrease because foreign goods will become relatively more expensive for the domestic country. Output in foreign countries is also a factor that impacts trade balance. Favorable exchange rate in foreign countries makes import more attractive (Blanchard 2006). For the rest of this thesis we assume that this condition holds; real depreciation leads to an increase in net export, i.e. positive effect of balance of payments.

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The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. Oliver Blanchard explains the condition as a relation “that the current exchange rate depends on the domestic interest rate, on the foreign interest rate, and on the expected future exchange rate. An increase in the domestic interest rate leads to an increase in the exchange rate. An increase in the foreign interest rate leads to a decrease in the exchange rate. An increase in the expected future exchange rate leads to an increase in the current exchange rate.” (Blanchard 2006: 424). The interest parity condition plays a central role in the real world; if expected rate of return is greater in one country in terms of another, it could lead to unnatural transactions of money between countries, which eventually could lead to shock in the monetary base.

2.7 Net Capital Outflow
Nouriel Roubini, a professor of economics and international business at New York University once said: “In today’s uncertain economy, it is understandable that people may turn to foreign currencies in search of profit and a sense of control over their mone(…) However, they may not realize it is a form of speculation, not investment, which may well end with lack of control and significant loss.” (Birnbaum 2008). Net capital outflow (NCO) is a method of determining the nature of a country‟s foreign trade. The NCO is the quantity of foreign assets held by residents of a given country less the quantity of domestic assets in that country held by foreigners. When the NCO is positive, the nation invests more outside than the world invests in it. When the NCO is negative, the world invests more in the country than the country invests in the world (Babylon 2009). When people begin to view a country as much less stable than they previously thought, they are willing to pull some of their assets out of the country in order to get them to a “safe haven.” This large and sudden movement of funds out of a country is called capital flight. An increase in NCO will lead to depreciation in the real exchange rate. Figure 6 shows the effect of capital flight. If people decide that it is too risky to

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keep their savings in a specific country, they will move their capital to a safer place, which will result in an increase in the country‟s NCO. Consequently, the demand for loanable funds will rise, and this drives up the interest rate, and at the same time shifts the NCO curve to the right. At the same time, in the market for foreign exchange, the supply of the country‟s currency will rise. This increase in the supply will cause the currency to depreciate, so the currency becomes less valuable compared to other currencies (Mankiw 2003). This model is intended to gain a better understanding of capital controls, which are in use in Iceland, and will be discussed later in this thesis. Figure 6: The Effect of Capital Flight

Source: Mankiw 2003. It is also worth mentioning that if interest rate rises, it will result in an increase in capital inflow, which increases the demand for the currency. When demand for currency increases, the value of the currency appreciates which results in higher imports and less exports. On the contrary, if the interest rate is lowered, it will increase the NCO and the demand for the currency will decrease. When the demand for currency decreases the value of the currency depreciates which leads to lower imports and higher exports.

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2.8 Exchange Rate
In an open economy with flexible exchange rates the nominal exchange rate is determined by supply and demand in the foreign exchange market. Changes in the money supply are neutral in the long-run. In the short-run, however, a decrease in the domestic money supply would reduce the output and raise the domestic real interest rate, which results in an appreciation in the current real exchange rate6 and the net export will fall. The decrease in the money supply is transmitted to foreign trading countries by the effects on its net export, which will increase. On the other hand, if we assume that the effect on net exports of the drop in domestic income is stronger than the appreciation of the exchange rate, net exports would increase as domestic residents would demand fewer goods from abroad. This would affect foreign countries, with a fall in net exports which results in output and real interest rate to fall in the short-run. This example illustrates how a domestic monetary contraction can lead to a recession in both the foreign country and the domestic country (Abel et al. 1998). When the model of the real exchange rate is determined, we combine the relationship between net exports and the real exchange rate with the model of trade balance. The real exchange rate is related to net exports because the lower the real exchange rate is, the less expensive domestic goods are relative to foreign goods, and the demand for net exports is greater as described in the Marshall-Lerner condition. The trade balance must be equal to the foreign investment, which means that net exports equal saving minus investment. This means that the quantity of currency supplied for net foreign investment equals the quantity of currency demanded for the net export of goods and services (Mankiw 1997). Under a fixed exchange rate system, nominal exchange rates are officially determined. If this determined exchange rate is greater than the fundamental value of the exchange rate as determined by supply and demand in the foreign exchange market, the exchange rate is said to be overvalued. If the central bank maintains the exchange rate at an overvalued level for a period of time, it has to use its official reserves to buy its own currency in the foreign exchange market. When a country has
6

Real exchange rate is the relative price of domestic goods in terms of foreign goods (Blanchard 2006).

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tried to maintain an overvalued exchange rate for too long, it will run out of reserves and be forced to devalue its currency. This can leave the country vulnerable for speculative attack; if financial investors expect devaluation, they may sell large quantities of domestic assets (Abel et al. 1998). This would lead to an increase in the NCO, which results in a depreciation in the real exchange rate, as explained in section 2.7.

3.0 Central Bank’s Actions and Policies
One of the most important institutions of any nation is the central bank. Central banks are different from commercial banks because they neither make loans to the public nor issue checking or saving accounts. Central banks are not concerned about making profit. They are governmental institutions, charged with providing certain services and achieving certain goals perceived to be in the nation‟s broad economic interest. A chief goal of central banks in industrial countries is to promote price- and financial stability. The following sections deal with the factors that can lead to short-run fluctuations in the money supply. Central banks are responsible for the long-run or trend behavior of the money supply. To be able to react and influence such circumstances central banks make forecasts to predict changes in future economic variables (Thomas 1997).

3.1 Importance of the Independence of the Central Bank
Credibility is very important for central banks. Their actions must be consistent with their policy, and their independence is essential. Oliver Blanchard describes how to establish credibility in three steps. The first step would be making the central bank independent. Making the central bank independent, and making it difficult for politicians to fire the central banker, makes it easier for the central bank to resist the political pressure to decrease unemployment below the natural rate. Politicians, who face frequent reelections, are likely to want lower unemployment now, even if it leads to inflation later. The second step is to give incentives to the central bankers to take

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the long view; to take into account the long-run costs from higher inflation. One way of doing so is to give them long terms in office, so they have a long horizon and have the incentive to build credibility. The third step may be to appoint a “conservative” central banker, somebody who dislikes inflation very much and is therefore less willing to accept more inflation in exchange for less unemployment when unemployment is at the natural rate. A conservative banker will be less tempted to embark on a monetary expansion when the economy is at the natural rate. Many countries have taken the steps described immediately above over the last two decades. As a result, central banks have become more independent, central bankers have been given long terms in office, and governments typically have appointed central bankers who are more “conservative” than the governments themselves (Blanchard 2006). The more stability there is in the economy that maximizes economic outcomes, the more credibility the central bank will have. By maximizing economic outcomes, we mean obtaining maximum employment, stable prices, and moderate long-term interest rates.

3.2 Policy Instruments
For central banks to maintain price- and financial stability, the banks use different instruments to influence the macroeconomic objective such as the level of output, the unemployment rate, and price level behavior. These intermediate variables include the quantity of money in the economy and short-term interest rates. As discussed in the quantity theory of money: If the economy is in recession, the central bank is likely to want to increase the quantity of money to stimulate economic activity. To bring about these changes, the central bank uses certain instruments, or tools, to control its monetary policy. Central banks are capable of controlling completely these tools to control the quantity of money in circulation and short-term interest rates. In general, there are four tools central banks use: open market operations, interest rate, reserve requirement and intervention on the foreign exchange market. In the following sub-chapters we will deal with these tools of monetary policy, beginning with open market operations (Thomas 1997).

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3.2.1 Open Market Operations The main instrument used to control the money supply is open market operations, where central banks sell and buy securities, which are in the form of government bonds. Brue and McConnell define bonds as: “… bonds consist largely of debt instruments such as Treasury bills (short term securities) and Treasury bonds (longterm securities) issued by the Federal government to finance past and present budget deficits. These securities are part of the public or national debt. Some of these bonds may have been purchased directly from the Treasury, but most are bought in the open market from commercial banks or the public. The purpose of these bonds is to influence the size of commercial bank reserves and therefore their ability to create money by lending.” (Brue & McConnell 1993: 282). Governments usually lend directly to the public by issuing securities such as treasury bills, notes, and bonds. Once in the public domain, these securities are in the “open market”, and central banks may purchase them. The reason why central banks do not buy these securities from the government is to keep as clear a line as possible between the treasury and the central bank. If the government has substantial influence over the central bank, it could coerce the central bank into purchasing excessive amounts of government debt. This would increase the nation‟s monetary base, money supply, and inflation rate. So, by separating the spenders from the money creators, fiscal and monetary authorities can act as checks and balances on one each other‟s actions (Marthinsen 2008).

3.2.2 Interest Rate7 Central banks can influence the money supply by loans to the commercial banks. Central banks set a specific interest rate (discount rate), which influences the supply of money to the commercial banks. Central banks can decrease the money supply by raising interest rates, as the public will tend to save more money. On the other hand when central banks increase the supply of money, it decreases the interest rate and the commercial banks will be more willing to loan money to the public and the public tends to save less money. The relation between the money supply and the interest rates can be related to the quantity theory of money. Lending to banks is very similar

7

This section is based on literature from Marthinsen (2008).

23

to buying bonds in an open market operation. In both cases the central bank creates money. There is one big difference from borrowing on the interbank market and borrowing from the central bank; loans from the central bank are a source of new liquidity to the banking system. In contrast, on the interbank market, for every financial intermediary that borrows, there must be a financial intermediary with surplus funds that lends. This means that it is impossible for all banks to be net borrowers in this market, and this is why central banks are often called lenders of last resort because if the banking system should run short of liquidity, financial institutions could turn, as a last resort, to the central bank for relief.

3.2.3 Reserve Requirements For precautionary and legal reasons the commercial banks need to keep an amount of reserves in some proportion of their checkable deposits. The central bank determines the reserve requirements ratio (R), and the amount of money the banking system generates with each currency unit of reserves is called the money multiplier (M). Changes in reserve requirements affect the money supply and cause the money supply multiplier to change. The money multiplier is the reciprocal of the reserve ratio, which means if the reserve requirements are 20 percent the money multiplier is 5. The money multiplier is determined in the following equation: ������ = 1/������ To simplify how the money multiplier works we can assume that the banking system as a whole holds a total of 100 ISK in reserves. It can have only 500 ISK in deposits as the multiplier generates 500 ISK of money where the reserves are 100 ISK and the money multiplier is 5. A rise in the reserve requirements reduces the amount of deposits that can be supported by a given level of the monetary base and will lead to a contraction of the money supply. On the other hand, a decline in reserve requirements leads to an expansion of the money supply because more multiple deposit creation can take place (Mankiw 2003).

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The reserve requirements are a powerful tool because it has a strong effect caused by the money multiplier. Small changes in the money supply are hard to engineer by varying reserve requirements. In the USA, in 1996, the checkable deposits were hovering near the $700 billion level. A ½ percentage point increase in the reserve requirements on these deposits would have reduced excess reserves by $35 billion. Because this decline in excess reserves would result in multiple deposit contraction, the decline in the money supply would be even greater (Mishkin 1997).

3.2.4 Foreign Exchange Market Intervention The foreign exchange market intervention has the same effect on a nation‟s monetary base as open market operations, but the main difference between these actions is that foreign currency, rather than government securities, is purchased or sold. When a nation purchases foreign currency, it increases the nation‟s monetary base and therefore its money supply by injecting newly created reserves into the banking system. On the other hand, if the central bank sells currencies, it takes reserves out of the system and forces financial intermediaries to curtail their loans (Marthinsen 2008).

3.3 Goals of the Central Bank
The monetary policy goals of central banks include economic growth, low inflation, and stability of the currency. However, many economists believe that the main contribution that monetary policy can make to economic management in the long-run is to maintain low inflation. It is generally agreed that low inflation provides a necessary base for sustained economic growth and development. In some cases governments have set indicative inflation targets, with central banks expected to maintain the rate of inflation within a target band. Many governments and central banks have made low inflation an explicit policy objective. This is clearest in the case of central banks that have adopted inflation targeting as their strategy for implementing monetary policy (Efobi 2006).

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3.4 Inflation
“When the prices of most goods and services are rising over time, the economy is said to be experiencing inflation.” (Abel et al. 1998: 8). As previously discussed, the main goal of monetary policies is to maintain price stability. Mankiw explains how central banks control the inflation. “Thus, the quantity theory of money states that the central bank, which controls the money supply, has the ultimate control over the rate of inflation. If the central bank keeps money supply stable, the price level will be stable. If the central bank increases the money supply quickly, the price level will rise quickly.” (Mankiw 1997: 156). The value of each currency unit decreases when the supply of money is increased, which leads people to keep less currency on hand – for example, people are more likely to go more frequently to the bank or the automatic teller machine to make withdrawals. Similarly, inflation may induce firms to reduce their cash holdings by introducing computerized cash management systems or adding staff to the accounting department. The costs in time and effort incurred by people and firms who are trying to minimize their holdings of cash are called shoe leather costs. Another cost of perfectly anticipated inflation arises from menu costs, or the costs of changing nominal prices. When there is inflation and prices are continually rising, sellers of goods and services must use resources to change nominal prices. An example of menu costs is restaurants that must print new menu to report new prices frequently as a result of the inflation (Abel et al. 1998). Central banks follow economic policies to accomplish their objectives. Many economies have adopted inflation targeting with the aim of keeping the inflation on average as close to the target as possible. The practice of inflation targetry is largely a product of the 1990s although Sweden operated monetary policy with a price level target in the 1930s. New Zealand was the first country to adopt an inflation target in 1990 followed by Canada and Israel, the UK in 1992 and by many countries since. The advantage of the inflation targeting is that the central bank has a single objective for monetary policy. On the other hand the disadvantage of the inflation targeting could be that it is too narrow-minded. The cost of focusing on one economic variable could lead to disadvantage in other economic variables. The economic performance would not be maximized which could lead to an unstable financial system, although inflation is stable. If the objective is to keep inflation relatively low it could be

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reflected in high unemployment rate according to the Philips curve. Higher unemployment rate could mean that the production is going down and therefore economic growth (Bain 2003). Nobel Prize-winning economist Joseph Stiglitz has rejected the idea that the most appropriate way to cope with macroeconomic shock was through inflation targeting. He said that he is strongly opposed to rigid inflation targeting in all countries and believes that the world economic crisis was at least partly, the result of banks focusing excessively on inflation. He also said that the inflation targeting should be just one of the things that should be addressed, and argued that other factors affecting the economy, such as growth and financial stability should not be ignored (Parker 2009). Both monetary policy and fiscal policy are concerned about short-run economic performance, but monetary policy is preferably designed to increase gross domestic product (GDP) and to control inflationary pressure in the long-run. On the other hand, fiscal policy is normally associated with principles of short-run economic growth while controlling long-term economic expansion is associated with overheated economic activities (AcaDemon 2007). Therefore it is important that the central bank promotes the government‟s policies so they do not conflict with the inflation target. For example, if we assume that inflation is above the inflation target the government should not lower taxes or increase government spending.

3.5 Exchange Rate
Frederic S. Mishkin (1997) defines nominal exchange rate as the price of one currency in terms of another. The exchange rate affects the economy and our daily lives because when the domestic currency becomes less valuable relative to foreign currency, foreign goods and travel become more expensive. When the domestic currency rises in value, foreign goods and travels become cheaper. However, the nominal exchange rate gives only a part of the information that we need. Tourists thinking of visiting foreign countries not only think about how much foreign currency they will get for their domestic currency. They also evaluate how much goods will cost in the foreign country compared to their home country. This is known as the real exchange rate.

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3.5.1 Balance of payments8 When payments to and from foreigners are conveniently summarized, we get a balance of payments, which shows the payments made to foreigners and the receipts of funds from them. A deficit in the national balance of payments is similar to a deficit in a household‟s budget, which means that collectively the nation is paying out more money abroad than it is taking in. A deficit produces a demand for foreign exchange greater than supply, and as a result, the price of foreign money will rise – foreign exchange rate will appreciate in value relative to the national currency. Another way to explain this is that the supply of the national currency is greater than the demand for it on a foreign exchange market, so the national currency will depreciate in value relative to other kinds of money. On the other hand, surplus in the national balance of payments is the opposite, which means the nation is taking in more money than it is paying out. This produces a greater supply of foreign money than the demand for foreign money, so the prices will fall. As a result, the foreign exchange rate will depreciate, and the national currency will appreciate. When exchange rates are floating they react freely to demand and supply, they often generate self correcting changes in imports and exports and in other types of international transactions, which eliminate balance of payments deficits and surpluses. As explained earlier, when a nation is running a payments deficit, the price of foreign exchange will rise and foreign goods and services become more expensive. This means that the nation will import less, and at the same time it will probably export more because foreigners will find out that the nation‟s products are less expensive. This would result in lower balance of payments deficit. The same applies if a nation has payments surplus (the nation exports more goods than it imports). This results in cheaper foreign goods and the nation‟s products will be more expensive. This would increase imports and decrease exports, and thereby reduce the surplus.

8

This section is based on literature from Ritter, Silber and Udell (1997).

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3.6 Monetary Tools in Action9
Now we will consider how the monetary tools of the central banks are used in practice. In the following example we suppose that a nation had a low level of unemployment, but its inflation was beginning to rise at an unacceptable rate. Now the central bank wants to remove the inflationary pressures from the economy by contracting the money supply or reducing its rate of growth by increasing the reserve ratio, raising the interest rate, selling government securities in the open market, and/or selling foreign currencies in the foreign exchange market. These monetary actions have one thing in common: They will decrease the banking system‟s ability to lend. When the reserve requirements are increased, financial intermediaries react to the curtailed availability of reserves by raising interest rates in order to ration their reserves. When real interest rates are getting higher, it will discourage borrowers from taking new loans and would be enough to dissuade some consumers from financing new cars, televisions, appliances, vacations, and furniture. Also, higher rates would discourage businesses from financing marginal investment projects, e.g., new machinery, renovations or plant expansion. When the loan demand is falling, the demand for goods and service will also fall which leads business inventories to rise. When firms have excess inventories caused by a fall in the demand, firms might reduce production by running factories for fewer hours, cutting back labor hours, and/or laying off workers. This situation can be related to the AS-AD model because when the production is decreasing, the demand for factory inputs (i.e. labor and materials) would fall, putting pressure on suppliers to cut back employment and production. This will lead to a chain reaction of cause-and-effect events in the economy, which usually results in higher unemployment and a lower price level. Workers respond to lower income by reducing their demand for goods and services, and businesses would face even weaker demand. A central bank regulates a nation‟s money supply by using these four major tools. To adjust the money supply, they must change the monetary base and/or the money multiplier. The nation‟s monetary base changes due to open market operation, foreign exchange market intervention, and discount loans, while the money multiplier changes with the reserve requirements adjustments. Only transactions between central
9

This section is based on literature from Marthinsen (2008).

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banks and non-central bank counterparts change a nation‟s monetary base. This means that foreign exchange transactions by individuals, central bank swaps, and fiscal policies have no effect on a nation‟s monetary base.

4.0 The Objectives and Roles of the Central Bank of Iceland
In May 2001, a new Act on the Central Bank of Iceland entered into force. With the approval of the Prime Minister, the Bank is authorized to adopt an inflation target as a framework for the conduct of monetary policy, the main objective of monetary policy is to maintain price stability. An inflation target was adopted on March 27, 2001 through a joint declaration of the Government and the Central Bank. The target was intended to keep the twelve-month inflation as close as possible to 2.5 percent. If the inflation deviates by more than 1.5 percent in either direction, the Central Bank is obligated to present the Government with a report, which will be made public, explaining the reasons for the deviation from the target and the bank‟s reaction to the deviation. The Bank is required to publish an inflation forecast, which projects inflation two years into the future (Central Bank of Iceland 2002a). The Central Bank‟s approach to keeping to its inflation target is to use its main instrument in this matter, the interest rate on its loans to financial undertakings against collateral. The bank can also influence the exchange rate of the ISK and thereby domestic inflation by buying or selling foreign currency on the interbank market (Central Bank of Iceland 2002c). By law, the Bank shall also promote other objectives, such as maintaining foreign reserves and promoting an efficient and safe financial system, including domestic payments systems and with foreign countries, and other tasks consistent with its role as a central bank. The Bank shall support the economic policy of the Government as long as it does not deem it inconsistent with the objective of price stability. The Central Bank 's main objective should not be used to accomplish other economic factors, e.g. balance in net export unless it upsets the inflation target. With the approval of the Prime Minister, the Central Bank specifies a numerical inflation target (Central Bank of Iceland 2002a).

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Other roles of the Bank are to issue bank notes and to mint and issue coins or other currency that may circulate in place of banks notes or lawful coins. The Central Bank also accepts deposits from deposit institutions, which consist of commercial banks, savings banks, branches of foreign deposit institutions and other institutions and companies authorized by law to accept deposits from the public for safekeeping and investment. In addition the Bank shall compile economic and monetary data, provide opinions and advise the Government on all foreign exchange and monetary issues (Central Bank of Iceland 2002b).

4.1 Interest Rate
Inflation in Iceland has been unstable in the past and in an effort to manage the inflation the Central Bank has unsuccessfully kept interest rates high for several years. When the ISK grew less in value it added to inflationary pressure because Iceland imports so much of its goods, because of its isolated geographical position in the world. In recent days, however, politicians have been calling for lower rates (The New York Times 2008). The Central Bank has kept interest rates over 10 percent since autumn 2005, which has resulted in difficulties for households and firms. Þorvaldur Gylfason, a professor of economics at the University of Iceland, has criticized the Central Bank for its interest rate policy. Professor Gylfason (2007) stated that the interest rate set by the Central Bank has not worked as it should have. Furthermore, he explains it was a serious mistake abolishing the reserve requirements because the interest rate instrument alone is not effective enough.

4.2 Inflation in Iceland
Icelandic economy is very small with the population being around 300,000 (i.e. 0.3 percent of Germany or similar to the city of Aarhus in Denmark). Therefore the economy is more vulnerable to global economic fluctuation than it would otherwise be. In Figure 7 the history of inflation in Iceland is illustrated; it is clear that the price level has been very unstable. To examine the fluctuations in inflation it is important to

31

look back and study the actions of the Icelandic authorities when inflation was soaring.

Figure 7: Historical Inflation in Iceland

Twelve-Month Changes in the Consumer Price Index
100% 80% 60% 40% 20% 0% 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Source: Statistics Iceland 2009b.

Sigurður Snævarr analyzed, in his book Haglýsing Íslands, the history of inflation in Iceland and highlighted the main reasons for the inflation and actions of the Icelandic authorities to deal with it. During World War II prices were rising in Iceland and the average inflation was about 24 percent. The exchange rate of the ISK was devalued by 18 percent in April 1939. In 1941 wages were indexed to price level and the inflation after World War II can be explained by the inflation during the war, where the purchasing power was higher than the national economy could handle. The war in Korea in 1950-51 led to a high inflation all around the world. Raw material and fuel prices were rising rapidly as a result of speculations caused by the fear that the war would spread out and lead to a war between big powered countries. In March 1950 the ISK was devalued by 43 percent, which led to increase in domestic inflation. Because of the wage indexation, wages got higher as the price of foreign products was rising and consequently the domestic prices did too. The inflation rose rapidly from 1972 to 1975 and during 1975 the inflation peaked at 50 percent. Changes in the exchange rate system in the world (collapse of the Bretton

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Woods system) had a big impact on the exchange rate of the ISK, which was depreciating rapidly. In 1973 the oil prices were rising and the authorities devalued the ISK regularly which resulted in a huge deficit. In the years 1978 to 1983, inflation was stuck around 45 – 60 percent and one of the factors that induced this inflation was the oil crisis. In May 1983 the ISK was devalued by 14 percent and the inflation rose to 102.8 percent in August. The same year a stable exchange rate policy was adopted, this worked and in 1984 the inflation was around 30 percent. In 1984 there was a strike by employees in the public sector who got in the end a wage increase of 10 percent, the Government respond to this was to devalue the ISK by 12 percent which resulted in a 32.4 percent inflation in 1985. In the next two years the inflation got down to 18.8 percent. In 1988 the ISK was devalued three times and the inflation started to rise again and got up to about 26 percent. In 1990 the expansion in the economy was decreasing and unemployment was rising which resulted in diminishing inflation. The inflation in Iceland was at this time at the same level as in other Nordic countries and in 1993 the inflation was about 3 percent (Snævarr 2005). In 2008 the financial system in Iceland collapsed when the three major banks were nationalized. A great mistrust was on the financial system that lead to a large outflow of capital. This resulted in a collapse of the ISK, which further raised inflation to 18.6 percent in January 2009 (Statistics Iceland 2009a). Throughout history it can be clearly seen how the small Icelandic economy is dependent on the world economy. The combination of wage indexation and currency devaluation has at times resulted in a very high inflation in the past. Because Iceland is very dependent on imports, the currency fluctuation has made the inflation very unstable.

4.3 Relation Between Inflation and Interest Rates
Although the Central Bank of Iceland adopted inflation targeting in 2001 inflation still remained high. In response to the high inflation the Central Bank increased interest rates, from 5.3 percent in 2003 to 18 percent in January 2009. Figure 8

33

illustrates the development of inflation and interest rate from the period when inflation target was adopted. As can be seen, there seems to be a correlation between interest rate and inflation from 2001 to 2005. In 2006 the gap seems to widen which means that real interest rate was getting higher. The real interest rate is the nominal rate less the inflation. Under usual circumstances high real interest rate should have induced savings, which would have cooled down the economy. Figure 8: Relation Between Inflation and Interest Rate
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2001

Inflation Interest rate

2002

2003

2004

2005

2006

2007

2008

2009

Source: Statistics Iceland 2009b; Central Bank of Iceland 2009c.

The reason for the failure of inflation targeting is not completely clear, but a key factor seems to be that the massive growth in currency inflows effectively became a part of the local money supply which led to sharp exchange rate increases, giving the Icelanders an illusion of wealth. Icelandic firms and households were motivated to take loans in foreign currency due to lower interest rates elsewhere and the strong exchange rate (Danielsson & Zoega 2009a). This can be related to the interest parity condition where it is stated that the foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. In Iceland it seems like the condition did not hold, because lower interest rates elsewhere and strong exchange rate made the expected return on deposits more favorable in other currencies.

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4.3.1 Abolition of Reserve Requirements Iceland voluntarily abandoned the reserve requirements on banks as a monetary tool in 2003, because they felt their other tools were sufficient for the task at hand. Many countries have done the same thing in the past including Australia, Canada, Norway, and the United Kingdom (Marthinsen 2008). Reasons for the abolition of the reserve requirements are that the cost imposed on banks from reserve requirements means that banks, in effect, have a higher cost of funds than intermediaries not subject to reserve requirements, making them less competitive. Throughout the world, central banks have been reducing reserve requirements to make banks more competitive. Raising the requirements can cause immediate liquidity problems for banks with low excess reserves (Mishkin 1997). Since the inflation target was adopted, the Central Bank has been raising the interest rate in an attempt to keep the inflation down and reduce the money supply. In a country like Iceland, where inflation has been unstable in the past the use of interest rate alone is not effective. Small economies are vulnerable to economic fluctuations, which underlines the need for a strict monetary policy (Gylfason 2007). The banking sector posed a clear risk to financial stability because of its fast growth. The asset side of the balance sheets of the three largest banks was nine-fold the country‟s annual GDP at the end of 2007, a big change from year 2004 when they were roughly equal to one year‟s GDP. To reduce the risk, the Central Bank could have raised the minimum reserve requirement and linked them to the rate of expansion of each bank‟s balance sheet. It could have raised reserves and prevented the excessive exchange rate appreciation (Danielsson & Zoega 2009a). When the banking sector collapsed in October 2008, it was impossible for the Central Bank to back up their assets and provide liquidity.

4.4 Exchange Rate
4.4.1 The History of the Icelandic Krona Már Guðmundsson (2004), present governor of the Central Bank of Iceland, discussed how decisions in the past regarding the Icelandic currency and the exchange rate

35

policy, have influenced the development of the Icelandic economic affairs and the financial system. Iceland was a part of the Nordic currency union until the start of World War I. After the currency union ended, the ISK was equal to the Danish krona until 1922 when flexible exchange rate policy was adopted. The Icelandic currency was floating until 1925 when it was pegged to the British Sterling. The ISK was pegged to the British Pound until 1939, when the ISK was devalued by 18 percent and it was decided to peg the ISK to the US Dollar. The ISK was pegged to the US dollar until late 1973. From 1974 to 1983 the ISK followed a managed float regime. From 1983, fixed exchange rate was adopted for short periods of time to reduce the inflation, which was getting out of hand. The inflation was successfully reduced, but one of the main reasons behind the success was to fix the exchange rate in December 1989 at a reasonable rate. Flexibility in the exchange rate policy was increasing from 1989, which in the end resulted in a floating exchange rate policy in 2001.

4.4.2 Historical Exchange Rate of the Icelandic Krona10 The exchange rate of the ISK is determined on an interbank market with currencies. The interbank market has been operating in Iceland since 1993. The purpose of the market is to determine the exchange rate with regards to supply and demand of the ISK instead of one-sided decisions made by the Central Bank. After Iceland joined the European Free Trade Association (EFTA) in 1970 and the European Economic Area (EEA) in 1994, the freedom regarding foreign trade and capital flow increased. When Iceland joined the EEA they adopted legislation relating to the so-called “four freedoms11”. Because of this expansion, the Icelandic economy opened up and therefore the need for a currency market for ISK grew. Until 2001 the Central Bank was obliged to keep the exchange rate inside a certain deviation rate, which was widened twice because this rate was assumed to be too narrow and restricted further appreciation of the ISK. In Figure 9 it can be seen how the fluctuations increased when the deviation rate was abolished and the exchange rate was only determined by supply and demand. It should be noted that the blue line in Figure 9 is the exchange

10 11

This section is based on literature from Pétursson (2009). Free movements of goods, capital, services and persons.

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rate index, which was used until January 2, 2009. The green line indicates the new discontinued exchange rate index, which is now in use in Iceland. Figure 9: Exchange of the Icelandic Krona

Source: Pétursson 2009.

4.4.3 Balance of Payments in Iceland The Icelandic economy has been running a huge deficit in the last couple of years as can be seen in Figure 10. The strong exchange rate resulted in expansion of imported goods and services. At the same time exports became relatively more expensive for foreigners, which meant net export was decreasing which underlines that the Marshall-Lerner condition holds. As has been discussed earlier (section 3.5.1) a deficit produces a demand for foreign currency greater than supply, and as a result, the price of foreign money will rise – foreign exchange rate will appreciate in value relative to the national currency. According to this the ISK should have appreciated which should have resulted in a decreasing deficit. However, the ISK remained strong which resulted in continuing growth of the deficit.

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Figure 10: Balance on Current Account

10 0 -10 -20 -30 -40

% of GDP

2001 2002 2003 2004 2005 2006 2007 2008

Source: IMF 2009.

In March 2006 Danske Bank published a very critical report titled Iceland: Geyser crisis on the Icelandic economy where they described it as the most overheated economy in the OECD area. Based on the macro data alone, they thought the economy was heading for a recession in 2006-7. They also pointed out that the early indicators for financial crisis and concluded that Iceland looked worse on almost all measures than Thailand did before its crisis in 1997, and that it was only moderately more healthy than Turkey was before its 2001 crisis (Valgaren, Christiansen, Andersen, Kallestrup 2006). The report got a lot of attention and was very controversial in Iceland when it was published.

4.4.4 Foreign Exchange Reserves The Central Bank of Iceland is meant to be a lender of last resort for example when the commercial banks are running out of liquid funds. Low liquid funds could reflect in a failure in the banking operation where firms and the public borrow money. Foreign exchange reserves indicate the ability to repay foreign debt and for currency defense. The development of the Icelandic foreign exchange reserves parallel to the growth of the banking sector affected the credibility of the Central Bank. The size of the Icelandic commercial banks grew fast and therefore foreign exchange reserves were not large enough to back the banks up. Gylfi Zoega, a professor of economics at Birkbeck College, UK and the University of Iceland and Jon Danielsson, a reader in

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Finance at the London School of Economics wrote the report The Collapse of a Country where they explained several factors about the meltdown of the economy. They discussed the weak state of the Central Bank and its inaction as regards expanding the foreign exchange reserve parallel to the growth of the banking sector. “The Central Bank has remained weak, it had foreign exchange reserves (official reserve assets) of around 375 billion kronas (3.5 billion dollars) just before the collapse in an economy with a GDP around 1,300 billion kronas, just under 30% of GDP. While the reserve ratio is quite high, for example the comparable figure for Sweden was 7% at the end of 2007. However, the short-term liabilities of Icelandic banks in proportion to Iceland 's GDP were a staggering 211% at the beginning of 2008.” (Danielsson & Zoega 2009a: 5).

5.0 Collapse of the Icelandic Financial System
The three main Icelandic banks accounted for about 85 percent of the financial system and there was no doubt that their failure would lead to catastrophic effects on the Icelandic economy. The fact that the banking system grew 900 percent as a fraction of GDP from 2003-2007 made it highly unlikely that the Central Bank could act as an effective currency lender of last resort. No wonder the Icelandic circumstances were described as an extreme case by many economists around the world (Buiter & Slbert 2008). As mentioned earlier, Iceland joined the EEA in 1994 which meant among other things that Icelandic firms were able to open branches in the member countries. Before the collapse the Icelandic banks had branches and subsidiaries in several countries in Europe. Danielsson and Zoega state in their report Entranced by banking that “it is now clear that the government at the time committed a classic mistake in deregulation, allowing the financial sector to undertake high-risk activities without adequate regulatory structure.” (Danielsson & Zoega 2009b). The rapid expansion of the banking sector, mainly from borrowing in international credit, developed the biggest stock market bubble in the OECD while house prices doubled. It seems that neither the Central

39

Bank nor the Financial Supervisory Authority in Iceland attempted to limit the growth of the banks during their expansionary period (Zoega 2008). Fall of the U.S. investment bank, Lehman Brothers in middle of September in 2008, resulted in lack of confidence in the global financial market which affected Iceland‟s two largest banks, Kaupthing and Landsbanki, which anticipated problems borrowing in wholesale markets. Therefore, to ensure sufficient liquidity they decided to open high interest on internet savings accounts in the UK and later in the Netherlands (Danielsson & Zoega 2009b). Accurate information about these accounts is not available but some estimates have been reported in the media reports. Icesave accounts in the name of Landsbanki are estimated to have grown over £4 billion with 300,000 customers in the UK, similar to the population of Iceland (News.com.au 2008). Perhaps, this is the clearest example of mismanagement of the Icelandic financial system. In October 2008 Glitnir, the smallest of the three largest banks approached the Central Bank for help because of the anticipated liquidity problem. Because of lack of confidence in Glitnir´s collateral the Central Bank refused the request and decided to buy 75 percent of its shares, leaving Glitnir few options but to accept. Before the nationalization of Glitnir the government and the banks had repeatedly claimed that all of the three main banks were liquid and solvent. The collapse of Glitnir demonstrated that those statements were untrue which undermined the confidence of the Central Bank´s crisis management abilities. Credit rating companies such as Standard & Poor´s announced on the same day that credit rating of the Icelandic government as well as the banks was lowered. The consequence was that credit lines were withdrawn from the two remaining banks (Zoega 2008).

5.1 A Systemic Crisis
“In the event of a sudden failure, all of these payments would be frozen, causing a huge erosion of liquidity in the system, and leading to failed payments for a wide range of transactions.” (Evanoff & Kaufman 2005: 17)

40

This is how Douglas D. Evanoff and George G. Kaufman describe a systemic failure in their book Systemic Financial Crisis. Systematic failure described the situation in Iceland well following the collapse of the banking system. Icelandic and UK authorities had been for some time discussing the insurance deposits on the Icesave saving accounts in the UK. Landsbanki operated on a foreign market as a branch and therefore by EU Law was not a legal entity, which resulted in Icelandic regulation, supervision and insurance. However, Icelandic authorities were repeatedly reneged to admit guarantees on the deposits, which probably concerned UK authorities, especially because the accounts were growing fast. Because Landsbanki was under Icelandic supervision it should have been the Icelandic financial regulator to first take action to limit the growth of these savings accounts or to change the foreign operation of Landsbanki into a subsidiary. That should have been the normal step because the Central Bank was incapable of guaranteeing these foreign deposits (Danielsson & Zoega 2009a). On the 10th of October, Prime Minister Gordon Brown indicated how exasperated the UK government was. Gordon Brown condemned Iceland‟s handling of the collapse of its banks and its failure to guarantee the deposits of British savers. He said the handling of the banking collapse by the Icelandic government was “effectively illegal” and “completely unacceptable” (BBC.com 2008). The following course of events had serious consequences for Iceland because the UK authorities responded by using a clause in its antiterrorist laws to freeze the assets of Landsbanki in the UK, which then triggered the bankruptcy of the remaining bank, Kaupthing12. The immediate effect was a complete closure of the international part of the Icelandic payment system. Foreign banks were not willing to transfer funds between Icelandic financial institutions and abroad which made it impossible to transfer funds in or out of Iceland. This meant that the foreign exchange market collapsed on October 8th 2008 (Danielsson & Zoega 2009a). In September 2008, a month before the fall of the three major banks, their stocks accounted for 75 percent of the Icelandic stock exchange and their bonds about one
12

It should be noticed that these antiterrorist laws the UK authorities used against the Icelandic banks has never been used against a western country. So far this law has been used against Al-Qaeda, Talibans, North Korea and Zimbabwe. The Icelandic media asked the question what would have happened if the UK authority had used this terrorist law against big countries like U.S. Germany or France.

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fourth of the bonds market. After the fall of the banks Pensions-, securities-, and investment funds were heavily shocked as they saw their money vanished (Central Bank of Iceland 2009b). It seems like the Central Bank of Iceland and authorities didn‟t want to face the coming problem. Perhaps, it was their lack of understanding or their concerns about the consequences of a drastic intervention in their banking sector, which actually could have delayed the problem. The Icelandic banking model got a lot of criticism e.g. in the afore-mentioned report from Danske Bank, which was among many other published examples of criticism. It seems like these warnings were not paid attention to. On October 6th 2008, when they anticipated that the financial system was at a significant risk, the Icelandic Parliament passed an emergency legislation. They separated the foreign operations of the “old banks” to their newly created banks where domestic deposits and loans were kept. Perhaps, that was the action Icelandic authorities should have taken a few months earlier. It stands to reason that the systemic failure of the international part of the payment system affected foreign trade. Exporters could not transfer funds to Iceland to meet domestic cost and importers could not pay suppliers. Cash in Iceland was temporarily rationed and it became almost impossible to obtain foreign currency. Therefore the fundamental role of the Central Bank, to guarantee a natural payment system, failed (Danielsson & Zoega 2009a).

5.2 How Did the Central Bank of Iceland Handle The Collapse?
The Central Bank has been criticized for their mismanagement handling the collapse of the banks. Jón Steinsson, an assistant professor of Economics at Columbia University pointed out that the greatest mistake during the collapse was the bankruptcy of the Central Bank of Iceland. He believes that the bankruptcy is the biggest mistake in Icelandic history and should never been allowed to happen. He argued a case that the Central Bank made mistakes by lending the Icelandic banks hundreds of billions of ISK right before their collapse. He said that the collateral the

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Central Bank got had not been sufficient. They should instead have taken other assets from the banks which were more secure e.g. banks credits, such as loans to households and firms (Eyjan.is 2009). Danielsson and Zoega (2009a) think that an anticipated loan from Russia is evidence of the Central Bank‟s lack of understanding when dealing with the situation. The bank announced that it had been offered a £4 billion loan from Russia, which later turned out to be a kind of wishful thinking. Economists Buiter and Slbert (2008), mentioned earlier, criticized the Central Bank for their attempt to peg the currency during the deep fall. They criticized the bank for pegging the currency without having the reserves to support it and without imposing capital and exchange controls. They further explained this was one of the shortestlived currency pegs in history, i.e. lasted two days. Another factor that matters for the banks credibility is that on the October 15 2008, the Central Bank lowered interest rates by 3.5 percent to 12 percent, which they two weeks later raised up to 18 percent; exactly a 6 percent increase. Despite this hard criticism it is interesting to see that throughout history it seems to be a tradition in Iceland to appoint former politician as a governor at the Central Bank. Before the collapse, six of the last nine governors at the Central Bank were former politicians, i.e. former prime ministers, and ministers of finance, commerce, fisheries and education. In October 2005, Davíð Oddson was appointed chairman of the board of governors of the Icelandic Central Bank. Mr. Oddson, a former prime minister for thirteen years, had studied law and it appears that he had no expertise in economics and banking. It should be noticed that when he was appointed, two other governors were appointed at the same time, which means that for the first time in Icelandic history three governors were in charge of the Central Bank. In this context we would like to refresh readers´ minds how Oliver Blanchard (2006) described how the central banks establish credibility in section 3.1. One thing we would like to emphasize is that Mr. Blanchard explains that governments typically appoint central bankers who are more “conservative” than the governments themselves. By appointing former politicians to this high position, it can be argued that credibility diminishes; the reason is the close relation the governor could have with his former colleagues. On top of

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that it is a big question whether former politicians are generally speaking qualified enough.

5.3 Carry Trade and Central Bank Dilemma
The high interest rate set by the Central Bank in Iceland has made carry trade attractive for foreign investors. Carry trade is an opportunity to earn some extra income from interest payments you can receive when trading a currency pair. Investors always look for the highest rate of return when they put the money into an account somewhere. The same concept applies in the foreign exchange market (Jagerson & Hansen 2006). Jagerson and Hansen highlighted an interesting point in their book Profiting with Forex: “One exciting side note is that the exchange rate usually moves in the direction of the currency with the higher interest rate. So if you stay in the trade for the long term, you can make profits from both the interest payments and the pips you gain in the trade.” (Jagerson & Hansen 2006: 215). As stated in the interest parity condition when the condition is not in equilibrium it is more attractive to get higher rate of return in another country, in our case Iceland. Therefore the carry traders speculate against the interest parity condition to make a profit, which could lead to unnatural movement of money between countries. The Central Bank has publicly admitted that mistakes were made during the collapse. However, it seems like the monetary policy in general has been unsuccessful since the inflation targeting was adopted. The Central Bank has admitted that it was a mistake emphasizing too much keeping the inflation down. They point out that perhaps they should have focused more on keeping the exchange rate stable. The Central Bank tied its own hands so as to leave only the interest rate as its control instrument. It gave up reserve requirements on grounds that the banks did not want them; and it also failed to exercise moral suasion. Its efforts to restrain inflation by raising short-term rates (to 15 percent in 2008) had the effect of sucking in more carry trade capital, undermining the intended curbing of demand and leading the ISK to appreciate despite the huge external deficit (Wade 2008).

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Since inflation targeting was adopted it has most of the period been over its target rate, which has resulted in interest rates exceeding at times 15 percent. As mentioned earlier, the high interest rate both encourages domestic firms and households to borrow in foreign currency, and it also attracts currency speculators. The large inflow of foreign currency led to sharp exchange rate increases and speculators profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. The amount of hot money inflows is not publicly known, but it appears to have exceeded 50 percent of GDP. It is uncelar why this did not raise concernes with the authorities (Danielsson & Zoega 2009a). Because the currency inflows encouraged economic growth and inflation, the Central Bank was pushed into raising the interest rates further, which convinced investors that the carry trade would remain profitable. The economy was having its biggest bubble caused by the interaction between domestic interest rates and inflow of foreign currency. Because of this interaction, the exchange rate was increasingly out of touch with economic fundamentals, so a rapid depreciation of the currency was inevitable. This situation should have been clear to the Central Bank which should have prevented the exchange rate appreciations and built up reserves (Danielsson 2008). The Icelandic business model appears to have involved transforming firms into investment funds; not just the banks were heavily leveraged, a significant fraction of non-financial firms used borrowing, mostly in foreign currency, to expand their operation. In the period when the exchange rate was relatively strong compared to foreign currency, the banks started to offer house, car and other kinds of loans in foreign currency. At that time, it showed a completely wrong picture of the status of the loans and was a clear sign of risk in the financial system and the economy as whole. The Icelandic deposit system developed significantly, so that after the collapse 2/3 of all deposits were in foreign currency. As can be seen from Figure 11 below, external debt to GDP ratio increased drastically from the time when the banks were privatized in 2002. It should be noticed that 60 percent of the banks´ liabilities were to foreigners through the banks´ operations abroad (Central Bank of Iceland 2009b).

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Figure 11: External Debt to GDP-Ratio
900% 800% 700% 600% 500% 400% 300% 200% 100% 0%

Source: Central Bank of Iceland 2009d. After the repeated increase in the interest rate and failure in lowering inflation, the Central Bank was in some kind of dilemma because of its high interest rate. Although the inflation pressure was very little because of low inflation expectation, weak exchange rate and higher taxes, the Central Bank has been hesitant to begin their decreasing process on the interest rates. The reason why the Bank is hesitating to decrease the interest rates is its fears of money outflow from carry traders and speculators, which would result in a lower exchange rate which can be related to the earlier discussion of NCO. The most pessimistic thought that the currency would collapse because the previous massive inflow of money would seek to go out of the economy. As a result of high external debts, a collapse in the exchange rate meant that foreign loans increased, in some cases doubled. Based on a press release on February 9th of 2009 from the European Small Business Alliance, 80 percent of Icelandic firms are considered technically bankrupt (ESBA 2009). The deep fall in the currency seems to be a big factor in this shocking statistic as well the fact that domestic loans are indexed to the price level.

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5.4 Philips Curve in Iceland
Joseph E. Stiglitz (2001) wrote a paper on Iceland called Monetary and Exchange Rate Policy in Small Open Economies: The Case of Iceland. One of the subjects that Mr. Stiglitz addressed in the paper was a key problem that was facing Iceland. When the paper was written, the economy had been experiencing a boom since 1996 in the range of 4.5 percent to 5.5 percent. Unemployment had fallen below 2 percent in 1999 from 5 percent in 1995, and down to nearly 1 percent in late 2000. Although the statistics themselves were positive Mr. Stiglitz was concerned that the economy was overheated and that imbalances from this overheating had, within them, the seeds not just of the ending of the boom, but of a marked contraction. He also addressed that the inflation could get higher than the current inflation, 5.5 percent, in the near term due to the recent weakness of the ISK. There was also a little evidence that the costs of a well managed disinflation were particularly large, e.g. relative to the gains of the boom that preceded and led to the bout of inflation. To the contrary, there is evidence of a convex or nearly linear generalized Phillips Curve. Figure 12: Phillips Curve in Iceland 1990-2008
16 14 Inflation rate 12 10 8 6 4 2 0 0 2 1991 2001 2002 2007 2000 1992 2005 2004 1999 2003 1998 2006 1990 2008

2009

1993 1996 1995 1997 1994 4 6 8 10

Unemployment rate

Source: Statistics Iceland 2009b; Statistics Iceland 2009c.

As we can see on Figure 12, the Phillips curve for Iceland has shifted upwards in 2008 and to the right in 2009. The shift in the curve can be related to the change in the economic structure in Iceland. The model aggregate supply and aggregate demand

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provides an easy explanation for the menu of possible outcomes described by the Phillips curve. “The Phillips curve simply shows the combinations of inflation and unemployment that arise in the short-run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve.” (Mankiw 2003: 763)

6.0 Economic Recovery
The fundamental thing in the economic recovery program is to make the financial system work normally so it can serve households and firms in the usual way. The Central Bank needs to ensure that it regains its credibility. There are several tasks the bank needs to focus on, such as improving the control and organization of the financial system as well as supervision. However, the most urgent problem is to find a solution that deals with the high external debt firms and households are facing. The Central Bank is not enviable because the project seems unsolvable; therefore it is worth going into more details to shed a light on the magnitude of the problem. The outstanding debt of the private sector in Iceland is one of a kind in comparison with other nations, which have dealt with financial crisis that has led to debt crisis in the private sector. As seen in Figure 13, the outstanding debts of households and firms were approximately 500 percent of GDP in 2008 according to the Central Bank. In comparison, when the crisis hit Thailand in 1997 the debt ratio peaked at around 165 percent of GDP.

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Figure 13: Outstanding Debts of Households and Firms

1. The years in the brackets indicate when the financial crisis started in each country. Source: Central Bank of Iceland (2009b). Considerable amount of the debt was in foreign currency so when the ISK started to depreciate it affected the fragile balance sheets of households and firms. It should be noticed that households and firms had none or limited income in foreign currencies. While the inflation and the loan capital have been rising, the wages have been decreasing, which will lead to payment difficulties. This situation indicates that the credit system is in jeopardy, and there is a risk that more households and firms will default in the near future. This would lead to increasing need to write off loans, and therefore it is important to restructure the credit system. As regards debt in foreign currency, the banking sector needs to diminish these loans and convert them into loans in ISK (Central Bank of Iceland 2009b).

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6.1 The International Monetary Fund Agreement
As a part of the economic recovery, the Icelandic government decided to seek assistance from the International Monetary Fund (IMF) after the start of the financial crisis. An agreement was reached and an economic program was finalized by October 24, 2008. On November 19, the IMF approved upon a request a two-year stand-by arrangement. Iceland will receive $2.1 billion from the IMF. Additional loans, up to $3 billion, have been secured from Denmark, Finland, Sweden, Norway, Russia, and Poland. The Faroe Islands have also announced that they would lend Iceland $50 millions (The Icelandic Government Information Centre 2008a). The government and the Central Bank of Iceland in close consultation with the IMF formulated the economic program. The program focuses on three main areas; first, stabilizing the exchange rate and rebuilding confidence in the monetary policy. Second, reviewing and revising fiscal policy with the aim of maintaining a manageable level of public sector debt and debt service in spite of lost revenues and increased expenditures. And third, banking sector restructuring and reform of the insolvency framework in accordance with transparent, internationally principles (The Icelandic Government Information Centre 2008a). The IMF published a country report on Iceland in October 2009, where it was stated that external debt was considerably higher than expected. It is expected to peak at about 310 percent of GDP in 2009 and in 2014 the external debt is predicted to drop down to about 210 percent of GDP (IMF Country Report No. 09/306, 2009). Although Iceland‟s external debt ratio is very high Mike Flanagan, IMF Mission Chief for Iceland, pointed out that many large advanced globally integrated countries also have large external debt ratio. Many economies are well above 100 percent of GDP and some are over 200 percent, this can be seen in Figure 14. Even though it sounds like a high number, in an international perspective it actually is not too far off what is pretty normal (International Monetary Fund 2009).

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Figure 14: External Debt, 2008 (Percent of GDP)

Source: IMF Country Report No. 09/306 (2009).

Iceland is on the road to recovery and will continue to work closely and constructively with the IMF and several countries to address problems that have arisen in connection with the Government takeover of Iceland‟s three largest banks. Along with preventing sharp ISK depreciation, a key challenge ahead is to implement a comprehensive and collaborative strategy for bank restructuring, and ensure fiscal sustainability. As a part of the IMF agreement, the bank regulatory framework and supervisory practice are being reviewed with the goal to strengthen the safeguards against potential new crisis. During this process the Icelandic government has received advice and assistance from internationally acclaimed specialists from all around the world. Although the crisis has hit the economy hard, its foundation still remains strong. Iceland‟s clean energy, marine resources, strong infrastructure and well educated workforce, together with Iceland‟s close international cooperation, provide a firm basis to overcome the current economic difficulties and implement necessary reforms (The Icelandic Government Information Centre 2008b).

6.2 Capital Controls
When the Icelandic banking crisis started, in October 2008, the confidence in Icelandic financial assets diminished. This created the risk that the capital outflow

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would increase enormously, which would have very drastic effect on the exchange rate on the ISK, which had weakened already. A large amount of capital outflow at this time would have caused a great depreciation of the currency and more inflation than Iceland actually experienced. As mentioned earlier, households and firms were highly leveraged in foreign currency; therefore a further fall in the exchange rate could start a period where firms and households could go bankrupt (Danielsson & Zoega 2009a). Because of these circumstances, the Central Bank decided to hinder capital outflow temporarily to protect firms and households. As illustrated in the NCO section, if NCO is hindered, the real exchange rate will not depreciate as drastically. In the light of the danger that the economy was facing, the Bank found it inevitable to use capital controls to enhance the stability of the ISK when the foreign currency trading was opened again in the beginning of December 2008. In March 2009, the laws regarding currency trading were changed to increase the capital controls. Payments regarding import and export and foreign direct investment in Iceland were allowed, and payment of interest (out of the country) was also allowed if it was changed to a foreign currency before a specific time. According to the new laws, it was not possible to change the bonds that were issued in ISK to other foreign currencies when they were due. Instead, the amount that was due should be reinvested in other bonds, which have been issued in ISK (Central Bank of Iceland 2009a). The main prerequisite for alleviating the capital controls is that investors evaluate the risk of investing in Icelandic assets less than they have done until now. The exchange rate of the ISK depreciated 5 percent against the Euro from January 1, 2009 until August 2009. Forecasts on the other hand predict that the ISK will appreciate substantially more than 5 percent until 2011 (Central Bank of Iceland 2009a). The Central Bank has published in their Monetary Bulletin that when restructuring of the balance sheets of households and firms are done they will lose the capital control in steps with the purpose to diminish the outflow. Therefore the fall in the exchange rate is supposed to be less, but it is hard to predict what exactly will happen (Central Bank of Iceland 2009b).

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7.0 The Future Prospects of the Icelandic Economy13
In the OECD Survey on Iceland in September 2009, the future of monetary policy in Iceland is discussed. Macroeconomic policies in Iceland are facing a difficult time. The lack of satisfactory monetary policy outcomes under different regimes in past years points to the limitations of an independent monetary policy in a very small, open country like Iceland, particularly in the context of large capital inflows associated with global carry trade transactions. The Central Bank of Iceland needs to gain credibility, which it has lacked in the past. One of the main factors for inflation targeting to work is to have high credibility of the monetary authorities, which in turn, requires a perception that the Central Bank will not be influenced by political factors. As discussed earlier, this is not the case in Iceland where former politicians have been governors of the Central Bank over long periods. As a result, studies carried out before the regime switch in 200914, showed that Iceland ranked the bottom among industrialized nations in terms of central bank independence. To make inflation targeting operative, there is a need to make the Central Bank more independent. The unsatisfactory inflation performance was partly due to unavoidable errors in forecasting, where both the OECD and the IMF noted that the conduct of monetary policy showed a tendency to respond too timidly to the worsening inflation outlook. An example of this is the interest rate decision taken in December 2005. At that point, the Central Bank projected a two-year-ahead inflation to be just below 4 percent, the threshold above which the Central Bank is required to prepare detailed report explaining the reasons for the deviation from the target. Although the inflationary pressure was rising and the economy was overheated, the policy rate was only increased by 0.25 percent. As concluded in the 2006 OECD Survey, “the Central Bank’s announcements do not seem to be credible, The public does not seem to believe its statement that it will do whatever is necessary to hit the target.” (OECD 2009: 64). It is very important the Central Bank of Iceland improves its credibility, and to achieve this, the Bank needs to make clear that it stands ready to do what is necessary
13 14

This section is based on the OECD Survey on Iceland (2009). In January 2009, the president of Iceland gave the Social Democratic party a mandate to form a new government with opposition parties to tackle the crisis that had abruptly shattered decades of rising prosperity (McLaughlin 2009).

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to achieve its objectives. The Central Bank should take full responsibility for the tight monetary policy stance and explain clearly that this is needed to support the capital controls and prevent a catastrophic outflow of capital. The Central Bank can in this way demonstrate that it understands that tough policy choices will be needed in the years ahead and that it is prepared to implement them. In February 2009, amendments to the Act on the Central Bank of Iceland were introduced which were a welcome step for strengthening credibility. The establishment of a Monetary Policy Committee (MPC) and new qualification requirements for the governor and deputy governor should improve the governance structure of the Central Bank. It is also important to improve transparency and thus effectiveness of monetary policy, and leading political figures should not be nominated as members of the MPC to increase the independency of the Central Bank. The inflation target has to be revised, because the Central Bank has been targeting a price index, which includes a component which policy rate has a very limited influence on. No other central bank in any OECD member country targets an inflation measure which is affected by market housing prices to the same extent as witnessed in Iceland‟s official consumer price index. The conduct of monetary policy and lack of credibility can be related to Iceland‟s inflation problems, and in the OECD Survey it is stated that independent monetary policy may not be an effective stabilization tool in a very small open economy, such as Iceland. The degree of exchange rate pass-through to consumer prices is particularly high, which makes the exchange rate a very important channel for the transmission for monetary policy to real activity. It is worth mentioning that a small economy with its own currency and a fragile financial sector is prone to experience further booms and busts, no matter what the stance of monetary policy will be. The current crisis have proved that it will also be crucial that the global financial system becomes better regulated and more resilient, an issue that is, however, outside of the control of Icelandic policymakers. For the time being, Iceland‟s monetary policy framework will be focusing on stabilizing the financial market, and the IMF program will govern the policy. Icelandic authorities intend to remove the capital controls within the two-year life of the IMF program, which is a necessary step to restore Iceland‟s credibility. Now there is a tight monetary policy stance to support the external value of the ISK, since the capital controls do not work perfectly. Although the inflation target remains the long54

term goal, the monetary policy has shifted to an exchange rate target temporarily. It should also be noted that under the current circumstances exchange rate stability is an important factor in re-establishing price stability.

7.1 If Iceland Were to Become a Member of the EU
Iceland has now applied to join the EU, but although Iceland‟s monetary policy credibility has been seriously damaged by the financial crisis, even before the crisis, unsatisfactory inflation outcomes had already undermined the credibility of the monetary framework and, consequently, inflation expectations were poorly anchored. It takes time to rebuild credibility, and even then, maintaining it might be very difficult. In the mean time, risk premiums on ISK assets will remain high (OECD 2009). After the collapse of the Icelandic financial system the previous Prime Minister, Geir H. Haarde, said that Iceland was prepared to consider a variety of options to solve the currency problem in Iceland. One of those options was to adopt the euro without joining the EU (The Straits Times, 2008). For Iceland to achieve the macroeconomic conditions for euro adoption – low inflation, stable exchange rate and low deficits and debts – will pose a difficult policy challenge in the years ahead. But this would in any case be an important ingredient in securing the necessary macroeconomic stabilization following the crisis. As a result, a euro area entry is some time off, even under the most optimistic circumstances. As for now, monetary policy should be geared towards supporting the ISK and protecting the balance sheets of unhedged borrowers (OECD 2009). When Iceland applied for joining the EU, Professor Gylfason stated that Iceland‟s application was overdue. He went on and said the natural thing for Iceland to do would have been to join the EU with Austria, Finland, and Sweden in 1995 rather than let European Economic Area (EEA) membership suffice and forgo the benefits of full integration. While Norway had a good, maybe selfish, reason to remain outside the EU – the oil. Some believed that Iceland‟s wealth constituted a comparable justification for shunning the EU, pointing out that Iceland‟s pension funds amounting to about $100.000 per person in 2007 compared with the Norwegian petroleum fund,

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now pension fund, equivalent to $85.000 per person. At the same time, Iceland and Norway shared first place in the 2007 UN Human Development Index, which reflected the purchasing power of national income as well as life expectancy and education. But, wealth in Iceland was an illusion because the ISK, and hence also Iceland‟s per capita national income measured in dollars or euros, was overvalued, which is partly the cause of excessive inflow of short-term foreign capital attracted by a misguided monetary policy. After the crash, Iceland‟s pension funds amount perhaps one-half of Norway‟s because the ISK has lost more than a half of its value on top of the decline in asset prices. The high historical inflation in Iceland, where the ISK has lost 95.95 percent of its value against the Danish krona since 1939 when the two traded at par, is a sign of sloppy policies and shaky institutions (Gylfason 2009). In the past, opinion polls have always shown a large opposition against EU membership, and in 2008 Iceland was the only Nordic country that had not even organized a referendum on EU membership. The reasons why Iceland never wanted to join the EU are the rich fishing grounds around the island, but at a time a strong and very expansive banking sector became an argument too. When the latter collapsed, the argument disappeared as well, and the EU wind on Iceland shifted direction radically. According to opinion polls after the crash, there was a large majority favoring accession to the EU. Because the shift in opinion, Jón Baldvin Hannibalsson a former Icelandic Minister of Foreign Affairs, directly asked European Commissioner Olli Rehn how soon Iceland could become a member of the EU. Olli Rehn responded by saying that Iceland could count on an express treatment, if it were to apply, and join the Union already during 2009 and he added the same applied for Norway. Because Iceland and Norway are already members of the EEA, and about three quarters of EU legislation is therefore already in place in the two Nordic countries, Olli Rehn cited this as the reason why he thinks integration into the EU would be so easy to complete. Obviously this plays a big role in why Iceland might be allowed to take a shortcut in joining the EU, but the question is if that is really the only reason. The advantages that Icelandic and Norwegian membership could bring to the EU probably play an even bigger role. Although Iceland is virtually bankrupt due to their high debt position, it is not like the country has become an underdeveloped country, or would become in the near future. Chances are that Iceland would become a net payer to the EU within a relatively short period, certainly when compared to

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countries like, Bulgaria, Croatia or even Spain or Portugal. If it were up to the last two countries, Iceland could probably join the EU already next week, because of the access of Icelandic waters when it comes to fishery. This would affect the Icelandic economy in the long-run so it is perhaps risky to rush into EU membership to solve a short-term problem (Laenen 2008). The main challenges for the EU membership negotiations is the harmonization of Iceland‟s agriculture and fishery policies, where liberalizing trade in agricultural goods and reaching an agreement over the management and exploitation of Iceland‟s fisheries are both likely to entail some costs. The fishing industry is a part of Iceland‟s national identity and is an important economic sector; in recent years it has accounted for 7 percent of GDP and over 30 percent of merchandise exports. Iceland‟s fisheries policy has often been regarded as a model to follow, while the EU common fisheries policy has produced unsustainable fish stocks and a weak fisheries sector. In April 2009, the European Commission said that 88 percent of the EU´s fish stocks are over exploited. If we assume that a compromise on the fisheries can be reached and the EU application is successful, euro area membership appears to be the most logical strategy to stabilize the economy, as regards Iceland‟s high and volatile inflation. This would also eliminate exchange rate risk and open access to the large capital market, which would lower Iceland‟s real interest rates towards euro area levels (OECD 2009).

7.2 Economic Forecasts
After a period of high growth, low unemployment rate and with rising debt, the Icelandic economy is going into a period of contraction. The economy will be going from one based on consumption, speculative investment, and international borrowing to one based on production, exports, and a current account surplus. The IMF published a forecast on Iceland‟s real economy in their country report in October 2009. They predict that GDP will decrease by 8.5 percent in 2009, 2.5 percent in 2010 and in 2011 there will be growth which means GDP will go up again. When GDP changes it will have a variety of consequences in the economy. A good way to simplify the effects is to think of the theory of aggregate supply and aggregate

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demand. Oliver Blanchard went through four underlying steps in his book Macroeconomic to show the relation between GDP and inflation. The first step is when there is a decrease in output, employment rate will go down. In the second step, a decrease in employment will lead to increase in unemployment. As IMF forecasts, unemployment will reach 10.6 percent in 2010 and then it will go down steadily to 4 percent in 2014. The third step is that due to higher unemployment rates, the wage setters are in a good position to negotiate for lower wages because workers find it more difficult to go elsewhere looking for better wages. The fourth step is when real wages have decreased, the price level will decrease as well. With lower real wages the purchasing power parity will decline and therefore consumption will decrease which leads to a lower price level. The IMF forecasts that real wages will decrease on average by 7.5 percent in 2009 compared to 2008 and by 2.6 percent in 2010 compared to 2009. The IMF further predicts that private consumption will fall by 17 percent in 2009 and further in 2010 i.e. 4.5 percent. In the IMF report it can also been seen that inflation will rapidly decline, or by 4.4 percent on a twelve-month inflation. In the end of 2010 inflation is expected to reach its target, 2.5 percent (IMF Country Report No. 09/306 2009). As the AS-AD curves indicate, when aggregate demand decreases, the price level will decline, and when aggregate supply decreases, the price level will decline further over the medium-run. It should be noticed that the relation between unemployment and the price level can also been seen through the Phillips curve. According to the extension of the IS-LM relation, we can assume that the GDP will continue to decrease while the inflation rate is falling. The reason for the decline in GDP can be explained through declining in investments and consumption by firms and households. When the inflation is expected to decrease, firms and households would rather hold back their spending until the inflation reaches its target. At this time GDP will start to rise again. More detailed information on the main Icelandic economic indicators and forecasts can be seen in Appendix.

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8.0 Conclusion
In the past decades, inflation has been very unstable in Iceland, and as the country is very dependent on imports, fluctuations in the world economy have had big impact on the national economy. From 1939 to 1988 the ISK was devalued on a regular basis and the combination of the devaluation and wage indexation, has resulted in a high inflation rate in the past. In 1993, the inflation got down to a level similar to what it is in the other Nordic countries, which caused the unemployment rate to rise. From 1996 to 2001 the Icelandic economy experienced a boom and unemployment fell down to nearly 1 percent in the year 2000. Joseph E. Stiglitz pointed out in 2001 that the economy was overheated and the imbalance would lead to a contraction and the inflation could get higher due to the weakness of the ISK. In 2001 inflation targeting was adopted, and the intention was to keep the twelve-month inflation as close as possible to 2.5 percent with a deviation of 1.5 percent in either direction. The main instrument used for attaining the inflation target is the interest rate on the Central Bank‟s loans to financial undertakings against collateral. The Central Bank also influences the exchange rate of the ISK and thereby domestic inflation by buying or selling foreign currency in the interbank market. Since the inflation targeting was adopted it has been over its target rate for most of the time, which has resulted in high interest rates, exceeding 15 percent at times. The Central Bank had tied its own hands so as to leave only the interest rate as it main control instrument, when it gave up the reserve requirements in 2003. In efforts to restrain the inflation, the Central Bank raised the interest rates. The high interest rates attracted foreign capital, which lead to sharp increase in the exchange rate, and speculators profited from both the interest rate difference between Iceland and abroad as well as the exchange rate appreciation. The currency inflows encouraged economic growth and inflation, which pushed the Central Bank to raise interest further. This situation convinced investors that carry trade would remain profitable, which resulted in an exchange rate that was increasingly getting out of touch with economic fundamentals, so rapid depreciation of the currency was inevitable. This situation should have been clear to the Central Bank which should have prevented the exchange rate appreciations and built up reserves. Because of the exchange rate appreciations, the newly privatized banks started to offer loans in foreign currencies

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that resulted in the external debt to the GDP ratio increasing drastically. Because of the external debt ratio and price indexation on loans in the domestic currency, the Central Bank was hesitant about lowering the interest rates, which could lead to outflow of capital and therefore depreciation of the ISK. The main reason why the financial crisis was so severe in Iceland is that the banking system grew 900 percent as a fraction of GDP from 2003-2007. This rapid expansion of the banking sector in Iceland, mainly from borrowing in international credit, made it highly unlikely that the Central Bank could act as an effective currency lender of last resort. The Central Bank has been criticized for mismanaging the collapse of the banks, where it made mistakes by e.g. lending the Icelandic banks hundreds of billions ISK, against insufficient collateral, right before the collapse. In October 2008, all three major banks collapsed and were nationalized. Before the nationalization of the banks, the Government and the banks had repeatedly claimed that these banks were liquid and solvent. The collapse of the first bank demonstrated that those statements were untrue which undermined the confidence of the Central Bank‟s crisis management. When the banking crisis started, confidence in Icelandic financial assets diminished, which created the risk that capital outflow would increase enormously. This would have drastic effects on the exchange rate of the ISK that had weakened already. The Central Bank found it inevitable to use capital controls to enhance the stability of the ISK, to protect firms and households because they were highly leveraged in foreign currency. A further depreciation in the currency would also have lead to a further increase in inflation. A part of the economic recovery was to seek assistance from the IMF, whose program in Iceland focuses on three main areas: stabilizing the exchange rate and rebuilding confidence in the monetary policy, reviewing and revising fiscal policy, and banking sector restructuring and reform of the insolvency framework in accordance with transparent, internationally principles. As for now, Iceland‟s monetary policy framework will be focusing on stabilizing the financial market and the IMF program will govern the policy. The conduct of monetary policy and lack of credibility can be related to Iceland‟s inflation problems in the past. The exchange rate is a very important for the Icelandic economy, because the degree of exchange rate pass-through to consumer prices is

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particularly high. Although the inflation target remains the long-term goal, the monetary policy has shifted to an exchange rate target temporarily because exchange rate stability is an important factor in re-establishing price stability. It is clear that Iceland has entered a period of contraction, where the GDP is predicted to decrease by 8.5 percent in 2009 and by 2.5 percent in 2010. The inflation peaked at 18.6 percent in January 2009, but is predicted to rapidly decline and in the end of 2010 it is expected to reach its target at 2.5 percent. Although the crisis has hit the economy hard, its foundation still remains strong. Iceland‟s clean energy, marine resources, strong infrastructure and well educated workforce will provide a firm basis to overcome the current economic difficulties and implement necessary reforms.

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References
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Mankiw, N. Gregory (2003). Principles of Economics. 3rd Edition. USA: Thomson/ South Western. Marthinsen, John E. (2008). Managing in a Global Economy; Demystifying International Macroeconomics. 5191 Natorp Boulevard Mason, OH 45040, USA: Thomson Higher Education. Mishkin, Frederic S. (1997). The Economics of Money, Banking, and Financial Markets. 5th Edition. USA: Addison-Wesley. Ritter, Lawrence S.; Silber, William L.; Udell, Gregory L. (1997). Principles of Banking, and Financial Markets. 9th Edition. USA: Addison-Wesley. Snævarr, Sigurður (2005). Haglýsing Íslands. Reykjavik, Iceland: Mál og Menning. Thomas, Lloyd B. (1997). Money, Banking, and Financial Markets. USA: McGrawHill Internatinal Edition. Wachtel, Paul (1989). Macroeconomics; From Theory to Practice. USA: McGrawHill International Editions.

Reports and Articles Buiter W. H. & Slbert A. (2008), „The Icelandic banking crisis and what to do about it: The lender of last resort theory of optimal currency areas’. CEPR Policy Insight, No. 26. Available from: http://www.cepr.org/pubs/PolicyInsights/PolicyInsight26.pdf (Accessed 3 November 2009). Central Bank of Iceland (2009a), “Afnám Gjaldeyrishafta.” Reykjavik, Iceland. Available from: http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=7214 (Acessed 12 October 2009). Central Bank of Iceland (2009b), “Monetary Bulletin.” Reykjavik, Iceland. Available from: http://sedlabanki.is/?PageID=287&NewsID=2287 (Accessed 9 November 2009).

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Danielsson, Jon & Zoega, Gylfi (2009a), “The Collapse of a Country”. 2nd Edition. Available from: http://www.hi.is/files/skjol/felagsvisindasvid/GZ_og_JDengpublished-3-jdgz-final.pdf (Accessed 15 September 2009). Danielsson, Jon & Zoega, Gylfi (2009b). “Entranced by banking.” VOX. Available from: http://www.voxeu.org/index.php?q=node/3029 (Accessed 3 November 2009). Euroweek (2008), “Iceland saga ends in banking system collapse”, London. Available from: http://proquest.umi.com.www.baser.dk/pqdlink?did=1591790241&Fmt=7&client Id=53681&RQT=309&VName=PQD (Accessed 26 October 2009). Guðmundsson, Már (2004), “Gjaldmiðillinn og íslenska fjármálakerfið”. Available from: www.cb.is/uploads/files/PM043_8.pdf (Accessed 26 October 2009). Gylfason, Þorvaldur (2009), “Iceland warms to Europe.” VOX. Available from: http://vox.cepr.org/index.php?q=node/3796 (Accessed 3 November 2009). IMF (2009), “World Economic Outlook: Crisis and Recovery”, Washington, D.C. Received via e-mail on September 7th 2009. Available from: http://imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf IMF Country Report No. 09/306 (2009), “Iceland: Staff Report for First Review under Stand-By Arrangement and Requests for Extension of the Arrangement, Waivers on Nonobservance of Performance Criteria, and Rephasing of Access.” Washington, D.C. Available from: http://www.imf.org/external/pubs/ft/scr/2009/cr09306.pdf (Accessed 9 November 2009). IMF Country Report No. 09/52 (2009), “Iceland: Stand-By Arrangement – Interim Review Under the Emergency Financing Mechanism.” Washington, D.C. Available from: http://www.imf.org/external/pubs/ft/scr/2009/cr0952.pdf (Accessed 23 September 2009).

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McLaughlin, Kim (2009), “Iceland begins building new government.” UK, Reuters. Available from: http://uk.reuters.com/article/idUKLR174003 (Accessed 21 November 2009). OECD (2009), “OECD Economic Surveys: Iceland” Volume 2009/16. Received via e-mail on September 7th 2009. Available from: http://puck.sourceoecd.org/vl=2256339/cl=49/nw=1/rpsv/cw/vhosts/oecdjournals /03766438/v2009n16/contp1-1.htm Pétursson, Vilhjálmur (2009). “Gengi íslensku krónunnar: Sagan og sveiflur”, Reykjavik, Iceland, University of Iceland. Available from: http://hdl.handle.net/1946/2555 (Accessed 11 October 2009). Stiglitz, Joseph E. (2001) “Monetary and Exchange Rate Policy in Small Open Economies: The Case of Iceland.” Central Bank of Iceland, Working Papers No. 15. Available from: http://sedlabanki.is/uploads/files/WP-15.pdf (Accessed 23 September 2009). Valgreen C., Christiansen, L., Andersen P. P., Kallestrup R. (2006), “Iceland: Geyser Crisis”, Denmark, Danske Bank. Available from: http://danskeanalyse.danskebank.dk/link/FokusAndreIceland21032006/$file/Gey serCrises.pdf (Accessed 2 November 2009). Wade, Robert (2008), “Iceland pays price for financial excess”, Financial Times. Available from: http://www.ft.com/cms/s/0/061070b8-4781-11dd-93ca000077b07658.html?nclick_check=1 (Accessed 21 October 2009). Zoega, Gylfi (2008). “Iceland faces the music.” VOX. Available from: http://vox.cepr.org/index.php?q=node/2621 (Accessed 3 November 2009).

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http://www.academon.com/Comparison-Essay-Monetary-Versus-Fiscal-PoliciesConflict-or-Cohesion/100882 (Accessed 2 November 2009). Babylon (2009), “Definition of Net capital outflow” Babylon‟s free dictionary. Available from: http://dictionary.babylon.com/Net%20Capital%20Outflow (Accessed 17 November 2009). BBC.com (2008), “Brown condemns Iceland over banks”, London, BBC. Available from: http://news.bbc.co.uk/2/hi/uk_news/politics/7662027.stm (Accessed 26 October 2009). Birnbaum, Jane (2008), “While Alluring, Foreign Currencies Can Be Elusive”, USA, The New York Times, Available from: http://www.nytimes.com/2008/04/05/business/05money.html?_r=2&ref=business &oref=slogin (Accessed 28 October 2009) Central Bank of Iceland (2002a), “History”, Reykjavik, Iceland. Available from: http://www.sedlabanki.is/?PageID=192 (Accessed 8 September 2009). Central Bank of Iceland (2002b), “Objectives and roles”, Reykjavik, Iceland. Available from: http://www.sedlabanki.is/?PageID=188 (Accessed 8 September 2009). Central Bank of Iceland (2002c). “Inflation target”, Reykjavik, Iceland. Available from; http://sedlabanki.is/?PageID=179 (Accessed 8 September 2009). Central Bank of Iceland (2009c), “Central Bank interest rates”, Reykjavik, Iceland. Available from: http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=2509 (Accessed 25 September 2009). Central Bank of Iceland (2009d), “External debt”, Reykjavik, Iceland. Available from: http://sedlabanki.is/?pageid=552&itemid=a55be3a0-9943-484e-a8de46d23f17ba25&nextday=26&nextmonth=11 (Accessed 4 October 2009). Danielsson, Jón (2008), “Why raising interest rates won’t work”, UK, BBC, Available from: http://news.bbc.co.uk/2/hi/business/7658908.stm (Accessed October 30 2009).

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Efobi, Chibuzo A. (2006), “An Autonomous CBN Soon? – Conclusion”, AllNairaPros. Available from: http://www.allnairapros.com/detail.asp?ItemID=128&CategoryID=9 (Accessed 4 October 2009). ESBA (2009), “ESBA calls on the British and Icelandic Governments to consider how their actions damage small businesses”, Brussels, European Small Business Alliance (ESBA). Available from: http://www.esbaeurope.org/F1BAA/EU_Advocacy/Latest_ESBA_PRs/9_February_2009_ESBA_ on_Icelandic_Issue.aspx (Accessed 5 November 2009). Eyjan.is (2009), “Jón Steinsson: Rangar ákvarðanir Seðlabankans dýrari en Icesave”, Reykjavik, Eyjan. Available from: http://eyjan.is/blog/2009/04/01/jonsteinsson-rangar-akvardanir-sedlabankans-dyrari-en-icesave/ (Accessed 4 November 2009). Gylfason, Þorvaldur (2007), “Seðlabanki í öngstræti”, Reykjavik, Visir.is, Available from: http://www.visir.is/article/20071101/SKODANIR04/111010165/1038 (Accessed 29 October 2009). International Monetary Fund (2009). “Transcript of a Conference Call on the Completion of the First Review of Iceland´s Stand-By-Arrangement”. Available from: http://www.imf.org/external/np/tr/2009/tr110209.htm (Accessed 9 November 2009). Laenen, Filip van (2008), “Will Iceland Join The EU in 2009?”, Zurich, The Brussels Journal. Available from: http://www.brusselsjournal.com/node/3714 (Accessed 3 November 2009). News.com.au (2008), “Britain vows to protect savers”, UK. Available from: http://www.news.com.au/business/story/0,27753,24467268-31037,00.html (Accessed 26 October 2009). Michelen, Abe (2006), “Edmund S. Phelps: Our new Nobel Laureate,” The General Section. Available from: http://cr4.globalspec.com/blogentry/478/Edmund-SPhelps-and-the-Phillips-Curve (Accessed 7 September 2009).

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Parker, Faranaaz (2009), “Stiglitz slams inflation targeting”, Johannesburg, South Afrika, Mail & Guardian online, Available from: http://www.mg.co.za/article/2009-07-09-stiglitz-slams-inflationtargeting (Accessed 30 October 2009). Pierce, Andrew (2008), “Financial crisis: Iceland´s dreams go up in smoke”, UK, The Telegraph, Available from: http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3147866/Financi al-crisis-Icelands-dreams-go-up-in-smoke.html (Accessed 18 October 2009). Prime Minister‟s Office (2009), “Statement by the IMF Mission to Iceland”, Available from: http://eng.forsaetisraduneyti.is/news-and-articles/nr/3527 (Accessed 26 October 2009). Schenk, Robert (2007), “Limitations of ISLM”, UK, CyberEconomics. Available from: http://ingrimayne.com/econ/index.htm (Accessed 18 November 2009). Statistics Iceland (2009a), “Consumer price index in October 2009”, Reykjavik. Available from: http://www.statice.is/Pages/444?NewsID=3735 (Accessed 2 November 2009). Statistics Iceland (2009b), “Consumer price index from 1939”, Reykjavik. Available from: http://www.statice.is/Statistics/Prices-and-consumption/Consumer-priceindex (Accessed 25 September 2009). Statistics Iceland (2009c), “Registered unemployment and unemployment rates by month 1980-2009”, Reykjavik. Available from: http://www.statice.is/Statistics/Wages,-income-and-labour-market/Labour-market (Accessed 25 September 2009). The Icelandic Government Information Centre (2008a), “Economic programme in cooperation with IMF”, Available from: http://www.iceland.org/info/icelandimf-program/ (Accessed 15 October 2009). The Icelandic Government Information Centre (2008b), “Iceland – the road to recovery”, Available from: http://www.iceland.org/info/faq/nr/6309 (Accessed 3 November 2009).

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The New York Times (2008), “Iceland cuts interest rates in bid to revive economy”, USA, Available from: http://www.nytimes.com/2008/10/15/business/worldbusiness/15ihticebank.4.16984008.html (Accessed 29 October 2009). The Straits Times (2008), “Iceland to adopt euro?” Available from: http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_308577. html (Accessed 15 October 2009).

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Appendix:

Main Economic Indicators
2001 2002 0.1 1.6 2.5 82.8 -1.5 2.3 2003 2.4 -4.8 3.4 82.1 6.1 3.4 2004 7.7 -9.8 3.1 80.7 7.0 1.4 2005 7.4 -16.1 2.1 81.9 12.7 2.6 2006 4.5 -25.3 1.3 83.1 3.6 2.6 2007 5.5 -15.4 1.0 83.3 5.6 3.8 2008 0.3 -34.7 1.6 82.6 -7.8 -3.8 2009 -10.6 0.6 9.7 2010 -0.2 -2.1 9.3 2014 -3.8 3.1

Real Economy: Real GDP (annual percent change) Balance on Current Account (% of GDP) Unemployment Rate (% of labour force) Labour Participant Private Consumption (annual percent change) Real Wages (annual percent change) Monetary: Consumer Prices (annual percent change) Interest Rate (highest observed nominal rate) Exchange Rate (Index 31.12.1991=100) Debt: External Debt (% of GDP) Asset Price: House Price (2000=100)

3.9 -4.3 1.4 83.6 -2.8 2.0

6.7

4.8

2.1

3.2

4.0

6.8

5.0

12.4

10.6

2.4

2.5

11.4 10.1 5.8 8.25 10.5 14.0 14.25 18 141.80 124.90 123.42 113.02 104.90 129.18 120.00 216.29

72.4

65.9

101.3

172.8

192.9

306.9 295.5 210.6

106.32 111.27 124.45 140.38 189.98 214.11 235.88 244.97

Source: IMF Country Report (2009); Economic Outlook (2009); Central Bank of Iceland; Statistics Iceland; Danielsson & Zoega (2009).

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References: 63 Danielsson, Jon & Zoega, Gylfi (2009a), “The Collapse of a Country” 64 McLaughlin, Kim (2009), “Iceland begins building new government.” UK, Reuters Web Pages AcaDemon (2007). “Comparison Essay #100882 :: Monetary Versus Fiscal Policies: Cohesion.” AcaDemon; Term Papers & Essays. Available from: 65 67 Parker, Faranaaz (2009), “Stiglitz slams inflation targeting”, Johannesburg, South Afrika, Mail & Guardian online, Available from: http://www.mg.co.za/article/2009-07-09-stiglitz-slams-inflationtargeting (Accessed 30 October 2009) 68 The New York Times (2008), “Iceland cuts interest rates in bid to revive economy”, USA, Available from: http://www.nytimes.com/2008/10/15/business/worldbusiness/15ihticebank.4.16984008.html (Accessed 29 October 2009) 106.32 111.27 124.45 140.38 189.98 214.11 235.88 244.97 Source: IMF Country Report (2009); Economic Outlook (2009); Central Bank of Iceland; Statistics Iceland; Danielsson & Zoega (2009).