Paddling in an Ocean of Global Money The problems of running independent monetary policy at times of large demand shock and ample global liquidity Central Bank of Iceland - International Monetary Fund The Challenges of Globalisation for Small Open Economies with Independent Currencies May 31 – June 1, 2007

Challenges of globalisation Iceland’s experiment Very small open economy Economically and financially integrated Smallest or second smallest country with IT central bank and floating currency Hit by exceptionally large positive demand shocks... Investment Financial liberalisation (privatisation + relaxed HFF lending rules) Lower taxes only partially offset by expenditure restraint ...at a time when global financial market conditions are exceptionally accommodative Question: How effectively can monetary policy stabilize the economy and contain inflation undir these conditions? Challenges of globalisation

Why has IT in Iceland not been more successful? Schocks too big to handle? Monetary policy mistakes? Faulty data Faulty models – forcasting Error of judgement Problems with monetary policy regime? Too small currency area Globalsation (or the recent global savings glut) has weakend the interest rate channel of the transmission mechanism  increasing uncertainty of MP transmisson Challenges of globalisation

VSOE transmission mechanism Labour demand Import prices Challenges of globalisation

Challenges of globalisation

Challenges of globalisation Conclusions Globalisation (or current global financial market conditions) may have increased the cost of being “out of sync” with the rest of the world for a VSOE Reduces benefits of an independent monetary policy Policy lessons: Case for monetary integration? Avoid large policy induced demand shocks CB communication is important (learn from 2001 mistakes) Liquid bond markets must be maintained even in the absence of borrowing needs The experiment is not finished!! Challenges of globalisation