1. 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

2. 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

4. 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

10. VSOE transmission mechanism
Labour
demand
Import
prices
Challenges of globalisation

11. Challenges of globalisation

12. 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