Lessons for Iceland from the monetary policy of
SwedenFredrik NG Andersson and Lars Jonung
Lund School of Economics and Management, and Knut Wicksell Centre for Financial
Studies, Lund University, Lund
June 4, 2018
Abstract
The purpose of this report is to derive lessons from inflation targeting in Sweden for the
choice of the future monetary policy regime of Iceland. Swedish inflation targeting has been a
success in terms of reducing inflation and inflation volatility, but real economic volatility is
not lower compared to previous periods. In addition, financial imbalances have grown rapidly.
A key lesson is that the Riksbank has closely shadowed the policy of the European Central
Bank due to financial integration. In other words, the Riksbank has behaved as if Sweden had
a fixed exchange rate. Our analysis clearly indicates that a small economy cannot pursue an
independent monetary policy from the rest of the world. Consequently, we suggest a fixedexchange rate arrangement for Iceland, preferably through a currency board. A currencyboard would provide exchange rate and price stability that would have positive effects on the
Icelandic economy. However, a currency board would also require domestic reforms toenhance price and wage flexibility as well as regulations on the financial system to minimize
the risk of future banking crises.
Key words: Monetary policy, inflation targeting, financial stability, Riksbank, Sweden,
Iceland, Central Bank of Iceland.
JEL codes: E4, E42, E43, E44, E47, E5, E52, E58, E621Introduction
Inflation targeting is presently the preferred monetary strategy worldwide. Central banks suchas the Federal Reserve, European Central Bank (ECB), Bank of England, Bank of Norway
and the Swedish Riksbank target inflation. This movement towards inflation targeting started
in the early 1990s with New Zealand and Canada as pioneers. Sweden followed soon after.
Inflation targeting was adopted in early 1993, when the Riksbank announced an inflation
target of 2 percent inflation as measured by the consumer price index (CPI), within atolerance band of plus/minus 1 per cent starting from 1995.
The purpose of this report is to draw lessons for Iceland from the experience of inflation
targeting in Sweden. We start with a short historical account of the evolution of monetary
regimes in Sweden. In the following section, Section 2, we describe how the Riksbank has
implemented the target. Here we show that the inflation-targeting regime of 1995-2017 should
not be regarded as a homogenous period; rather, the regime has evolved over time. In ourview, it is proper to make a distinction between three phases: first, the years of introducing
and establishing the inflation target, 1995-2000; second, the years of relative success, 20002007; and finally the years 2007-2017, a period of crisis and policy experiments.
Next, in Section 3, we turn to the record of inflation targeting, answering the question: is
inflation targeting a success in Sweden? Here we compare the macroeconomic outcome of theinflation-targeting period (1995-2017) with outcomes during the two previous monetary
regimes, the Bretton Woods period (1953-1972) and the “accommodation” (full employment)
regime (1973-1992). The answer is a mixed one. Inflation targeting has successfully reduced
inflation and inflation volatility. However, the real economy has been as volatile as inprevious regimes, and financial imbalances have grown to a scale never seen before.
Following our analysis of the macroeconomic performance under inflation targeting, we turnto a discussion of the monetary independence of the Riksbank in Section 4. We examine towhat degree the Riksbank has shadowed the policy of major central banks and to what degree
it has been able to implement an independent policy. Our results demonstrate the large
influence of the European business cycle and the monetary policy by the ECB on the
Riksbank. The Riksbank has almost behaved like a central bank with a fixed exchange rate byclosely shadowing the interest rate set first by the Bundesbank and from 1999 by the ECB.
This result suggests that a small open economy in a world of close financial linkages does nothave monetary independence even when the exchange rate is flexible. In Section 5, weconclude our discussion about the monetary policy of the Riksbank with a summary of thefirst quarter of a century of inflation targeting in five lessons, pertinent for the case of
Iceland. 1
1

A few studies of the Swedish experience of inflation targeting cover shorter periods, but
none covers the first 25 years of inflation targeting as we do here. The various contributions in
Jonung (2003) deal with the introduction of the new monetary regime and the first decade ofinflation targeting. The three reports by foreign economists on the policy of the Riksbank,2

We turn next to Iceland with our Swedish insights. Starting from the characteristics of the
Icelandic economy, we analyze the choice of monetary regime for Iceland in Section 6. We
consider the pros and cons of alternative flexible exchange rate regimes, including inflation
targeting, in Section 7. In the subsequent section, various fixed exchange rate arrangements
such as Icelandic membership in a monetary union and a currency board for Iceland are
discussed. Finally, based on our joint reading of Swedish and Icelandic monetary history, we
present our answer to the question: Which monetary regime is best for Iceland? Here we
stress that our choice of monetary regime should be supported by well-designed fiscal
policies, strict financial regulations and proper labour market behavior in order for the regime
to be sustainable and successful.

1. Monetary regimes in Sweden
The Riksbank is the world’s oldest central bank, tracing its roots back to 1668. Over the years,
Sweden has had a wide-range of different monetary regimes, including fixed exchange rates
under different metal standards (gold, silver and copper), and flexible exchange rates
combined with price level and inflation targeting.
Table 1 shows the monetary regimes since 1834. Twelve major regime changes have takenplace during this time. The most successful regimes, measured by their duration, have been
the silver and gold standards (39 and 41 years, respectively), followed by the Bretton Woods
system of fixed exchange rates to the U.S. dollar (22 years) and inflation targeting (21 years
so far). The average duration per regime is 16 years and the median duration is 11 years.
[TABLE 1]
Wars and major economic crises often cause regime changes. For example, the gold standard
was abolished at the beginning of the First World War. Sweden adopted a gold bullion
standard in the early 1920s, which ended at the start of the Great Depression in 1931. The
Riksbank then pioneered price level targeting for a few years before it returned to a fixedexchange rate by tying the Swedish krona to the British pound. 2 In 1939, Sweden shifted froma fixed rate versus the pound to one versus the US dollar.
International developments have also been a factor behind the choice of monetary regime.
The move from a silver standard to a gold standard in 1873 was taken to align Sweden withcommissioned by the Finance Committee of the Riksdag (the parliament), examine a limited
number of years, overlapping each other. See Giavazzi and Mishkin (2006), Goodhart andRochet (2010) and Goodfriend and King (2016).
2
Sweden was the first country in the world to experiment with price level targeting, based on
Knut Wicksell’s monetary theory of the determination of the price level (Jonung 1979). Thismodel provides today the theoretical foundation for inflation targeting3

similar changes across the world. Swedish membership in the Bretton Woods system startingin 1951 had a similar background.
A clear pattern emerges from the Swedish history of exchange rate arrangements. Since its
establishment, the Riksbank has consistently struggled to maintain a fixed exchange rate.
Time after time, the Riksbank has been forced to abandon the fixed rate and accept a flexible
exchange rate due to exogenous international or domestic events, notably wars and deep
financial crisis. As a rule, the Riksbank has always gone back to a fixed rate arrangement,
except in the case of the present regime of inflation targeting. Now inflation targeting
represents the longest period of a flexible exchange rate arrangement.

2. Inflation targeting in Sweden 1993-2017
The era of inflation targeting starting in 1993 is commonly viewed as a single homogenous
period. However, both the inflation target and the policy strategy behind it have evolved overtime. It is possible to distinguish three periods of inflation targeting. The borderlines between
these three periods are not precise, as the policy of the Riksbank has changed gradually.
In the first period, 1995-1999, the Riksbank developed the tools and strategy to implement the
new policy. In the second period, 2000-2007, the Swedish economy grew steadily after therecovery from the crisis of the 1990s. During these years, the Riksbank followed the new setof rules successfully.
In the third period, 2007-2017, the Riksbank introduced a new policy framework, re-defined
the inflation target twice, and came under heavy pressure from the global financial crisis andthe euro area debt crisis. Specifically, the policy strategy that emerged during the late 1990s
was modified in 2007, by moving from inflation forecasting to interest rate forecasting. In
2010, the tolerance band was abolished, only to be introduced again in 2017, now with a new
name: “variation band”. The performance of the Riksbank became a subject of much morecriticism during this period compared to the two previous periods.
Three governors have been in charge of the Riksbank in the period 1995-2017: Urban
Bäckström (1994-2002), Lars Heikensten (2003-2005), and Stefan Ingves from 2006. Eachgovernor has put his own mark on the Riksbank. However, the major changes to the inflation
targeting regime were not caused by a change in governor. Each adjustment was initiatedbefore the appointment of a new governor.
Next, we discuss the experience of Swedish inflation targeting in more detail. For simplicity,
we examine each period separately.

42.1 Establishing the inflation target 1993-1999
The Swedish economy displayed high economic growth and low and relatively stableinflation in the 1950s and 1960s when Sweden was member of the Bretton Woods system.
Macroeconomic stability was lost following the OPEC oil price shocks in 1973 (OPEC I) and1979 (OPEC II). Excessive wage claims pushed up inflation and eroded the competitivenessof Swedish exports. The Riksbank devalued the krona five times between 1976 and 1982 torestore competitiveness without disinflation.
After the “super-devaluation” of 16 percent in 1982, the export sector recovered and growth
improved. In November 1985, the Riksbank took a major step towards financial deregulation.
The outcome was a credit-fueled boom that, combined with competitiveness problems,
created a major economic crisis in the early 1990s. 3 Sweden established a unilateral peg to theEuropean Currency Unit in May 1991, but a series of speculative attacks against the krona,paralleling those against other Western European currencies, eventually forced the Riksbank
to abandon the fixed exchange rate in November 1992.
The krona was now floating. The Riksbank needed to consider new goals for monetary policy.
Inflation targeting appeared to be the best policy choice. Bank of Canada had pioneered
inflation targeting and the Riksbank reached out for advice. 4 A delegation arrived from
Ottawa to Stockholm within a week. In January 1993, the Riksbank on its own initiative
announced an inflation target, to come into effect from 1995. The Riksbank copied directly
the Bank of Canada’s set-up, including the tolerance band around the inflation target, meant
to illustrate that short-run volatility in consumer price inflation was outside the control of the
Riksbank (Bäckström 1995. 5
Actually, within the Riksbank there was some pessimism concerning the target of 2 percent.
Many regarded it as too ambitious given the recent experience of persistent double-digit
inflation. A rapid fall in the rate of inflation was not expected. For this reason, the Riksbank
decided to announce the target in 1993 but did not expect to meet it until 1995.
3

See Jonung et al (2009) on the boom-bust process initiated by financial deregulation in
Sweden.
4
As chief economist at the Riksbank, Krister Andersson took the initiative in 1992 to call the
Bank of Canada, as he had been impressed by the Canadian central bank policy when working
on the IMF team that prepared Article IV consultations with Canada. Andersson (2003) gives
a detailed account of the Canadian influence on the Swedish framework for inflation
targeting.
5
Sweden imported inflation targeting through Canada in a fairly rapid search process for a
new monetary regime. It took about two months – from the fall of the fixed krona rate in
November 1992 to the announcement of the inflation target in January 1993. The Canadianframework evolved in a much longer process of debate and interaction between the Bank of
Canada, the ministry of finance and economists at universities. See Laidler (2015) for an
account of the Canadian path to inflation targeting. On the other hand, Sweden has a much
longer tradition of debate about price level targeting starting from Knut Wicksell and DavidDavidson. See Jonung (1979).
5

The Riksbank was aware that the implementation of an inflation target was more challenging
than the management of a fixed exchange rate. With a fixed rate, the domestic interest rateequals the foreign interest rate plus a potential risk premium, reflecting expectations ofdevaluations, among other factors. Deviations from the policies necessary to maintain a fixedexchange rate cause capital flows that eventually can threaten the peg. With an inflation
target, the interest rate is set in accordance with the state of the domestic economy, which
requires a thorough analysis combined with a new communication strategy with the public.
New policy tools, policy strategies, economic models, and a new communication approach
had to be developed.
A period of innovation and experimentation began after the announcement of the inflation
target. One of the first steps was the introduction of the publication Monetary Policy
Indicators. The report provided information relevant for the Riksbank’s policy decisions andacted as an important communication tool (Riksbank 1997:4). Eventually, the publicationtransitioned into a more extensive Inflation Report in 1996. Initially, most of the analysis
focused on the past, but later reports shifted focus towards discussing possible future
developments. The publishing of the Riksbank’s inflation forecasts in 1997 was a significant
step in this direction.
Three underlying (or core) inflation measures were introduced in the late 1990s ascompliments to the consumer price index (CPI): consumer price inflation with a fixedmortgage rate (UND1X), imported consumer inflation (UNDIMPX) and domestic consumer
inflation (UNDINHX). All featured in the inflation reports in the discussion of recent inflation
developments, in particular when explaining why the target of 2 percent was not reached.
A new underlying index that removes the effect of changes in the mortgage rate wasintroduced in 2008 (CPIF) replacing the UND1X-index. 6 The Swedish CPI-index includes the
mortgage cost of owner-occupied homes. In the short run, CPI-inflation is therefore directly
affected by changes in the Riksbank’s repurchase rate (repo rate) via interest costs on
mortgage rate. If the repo rate is raised, CPI-inflation increases. Likewise, if the repo rate is
reduced, CPI-inflation decreases. In other words, when the Riksbank reduces the repo ratewith the aim of raising inflation over the medium term, the short-run inflation effect is the
opposite. 7 The Riksbank disregards this effect of a change in the repo rate on CPI-inflation byfocusing on the medium- to long-term inflation horizon, because “to try to counteract a
reduction in CPI created by the direct effects of interest rate cuts with further cuts would, in
terms of monetary policy, be tantamount to chasing one’s own tail”, (Heikensten 1999, p.10).

6

The Riksbank stopped producing and publishing alternative measures of inflation in 2008.
The only additional measure to CPI was the new CPIF index that excluded the effect ofchanges in mortgage interest rates.
7
Palmqvist (2013) demonstrates that the CPI for Sweden is more sensitive to changes in therepo rate than the CPI of other countries is to changes in the policy rates of their central
banks.
6

During periods of falling interest rates, such as 1995-1997 and 2008-2010, CPI-inflation
declined due to reductions in the repo rate. To isolate monetary policy from these short-term
effects, the Riksbank used UND1X/CPIF as its operational target. In 2017, the Riksbank
officially changed from targeting CPI-inflation to targeting CPIF- inflation.
By the late 1990s, the Riksbank’s communication and operational strategies were fully
developed (Heikensten 1999). Simply put, the goal was to keep CPI-inflation close to 2
percent, within the band of +/-1 percentage point. The monetary policy strategy was forward
looking and simple: “[t]he basic rule for monetary policy is simple: if forecast inflation one to
two years ahead is above/below 2 per cent, the repo rate shall normally be raised/lowered inorder to fulfil the inflation target. However, the rule is not applied mechanically and minor
deviations from the target may be weighed against other factors” (Riksbank 2000).
This first period of inflation targeting was relatively successful, judging from the behavior of
inflation. Inflation fell from a high level in the beginning of the 1990s and the public’s
inflation expectations became aligned with the Riksbank’s inflation target. Figure 1 illustrates
the successful disinflation of the Swedish economy. In the figure three measures of inflation
are included covering the period 1990Q1-2017Q2. The first measure is CPI-inflation, theofficial target between 1995 and 2017. The second measure is CPIF-inflation, the measure ofunderlying inflation until 2017 and the official target thereafter. The third measure is theperceived rate of inflation of households, obtained through surveys, where a representative
selection of respondents answers the question: “compared with 12 months ago, how many
percent higher do you think prices are now?” The perceived rate of inflation is a valuable
complement to official price indices as households to a major extent base their expectations of
future inflation on their perceived rate of present inflation. 8[FIGURE 1]
Inflation fell from 10 percent in 1990 to 5 percent in 1993 and further to 2 percent by late1995 according to all inflation measures. The Riksbank briefly tightened monetary policy in
1995-96 for fear of a return to the high inflation of the past. A reversal of the policy quickly
followed when inflation continued to fall. The trend of high inflation of the 1970s and 1980s
had finally been broken. Sweden had entered a low inflation regime for the first time since theearly 1960s.
Because of the new low inflation environment, the differential that had persisted between the
Swedish and the German/European nominal short-term interest rate disappeared (Figure 2).
From 1997 onwards, the Riksbank’s repo rate has closely followed first the rate set by theGerman Bundesbank, and since 1999, the rate set by the European Central Bank (ECB).
Periods of temporarily higher and lower inflation have emerged, but they have been brief and8

Jonung (1981) argues that perceived inflation is an excellent complement to Statistics
Sweden’s official consumer price index.
7the differences have been small. The average interest rate difference between Sweden andGermany between 1997 and 2017 is 0.0 percent, in other words nonexistent.
[FIGURE 2]
Public confidence or trust in the inflation target emerged almost immediately as judged by the
behavior of the inflation expectations of households and firms shown in Figure 3. Inflation
expectations have varied over time but they have moved within the tolerance band with few
exceptions since 1995. Initially, firms did not expect the Riksbank to achieve its target; their
expectations exceeded the upper tolerance band until 1996. Households, however, had greater
confidence in the policy of the Riksbank: their expectations were close to the 2 percent target
already in 1993. We stress that inflation expectations have varied over time as inflation hasvaried, but crucially they have stayed within the bounds of the tolerance band.
[FIGURE 3]

2.2 Inflation targeting as a success, 2000-2007
The inflation target was well established by the early 2000s. The Riksbank had developed thetools necessary to implement it, and the rate of inflation as well as the public’s inflation
expectations were anchored within the tolerance band. The first years of the new century prior
to the crisis of 2007 displayed high growth with no major economic shocks. The information
technology bubble (dotcom bubble) that burst in 2000 reduced growth temporarily but theeffect was small compared to the pattern of previous recessions.
Concerning monetary policy, the most notable change was the updated Riksbank act of 1988
(1988:1385), which came into force in 1999. It formalized the policy shift to inflation
targeting. The new act assigned two main goals to the Riksbank: maintaining price stability,and promoting a safe and efficient payments system. No exact number for the inflation target
was included in the law. After the new law went into force, the Riksbank decided by itself tomaintain the existing inflation target at 2 percent. The Riksbank became politicallyindependent from the Government with an independent Executive Board in charge ofmonetary policy decisions.
Because of the Riksbank’s new political independence, a need for external evaluations of the
Riksbank’s performance arose. The Standing Committee on Finance of the Riksdag decided
to undertake regular reviews of the Riksbank (Riksbank 2000). The first review wasundertaken in 2006 by Giavazzi and Mishkin (2006), covering the period 1995-2005; thesecond in 2010 by Goodhart and Rochet (2010), covering 2005-2010; and the third in 2016 by
Goodfriend and King (2016), covering 2010-2015.
Globally, financial imbalances began to emerge as reflected by rising house prices coupledwith rising household debt. Sweden followed this international trend; household debt
8

increased from 105 percent of disposable income in December 1999 to 158 percent in
December 2007 (see Figure 4). House prices increased in real terms by 79 percent during thesame period (see Figure 5). In metropolitan areas such as Stockholm, real house prices
increased by 150 percent, primarily driven by the rise in the price of tenant-occupied
apartments. 9 The real price of tenant-occupied homes increased by 250 percent between 2000
and 2007. Lower interest rates were the main cause of the rise in household debt and in house
prices. Declining domestic interest rates reflected declining global interest rates (Andersson
and Jonung 2015, 2016). 10[FIGURE 4][FIGURE 5]
The Board of the Riksbank became aware of the growing financial imbalances as early as in2003 when one member raised concerns about lowering rates as these “could aggravate house
price developments, resulting in a further increase in mortgages and household indebtedness.”(Riksbank 2003). However, the Riksbank decided against taking action and the policy focus
remained on achieving the inflation target.

2.3 Crises and policy changes 2007-2017
Following a decade of relative calm, the global financial crisis 2007/08 marks the start of anew phase for the Riksbank characterized by crises, uncertainty, continuous changes to boththe policy framework and the inflation target. The financial crisis and the ensuing euro area
debt crisis changed the economic landscape. Previously apparently stable economic
relationships disappeared. Several policy lessons from the early years of inflation targeting
appeared no longer valid. Expansionary monetary policy in the wake of the global financial
crisis contributed to a large and sustained rise in house prices. This made financial stability amajor policy concern. New circumstances and experiences challenged the establishedconsensus on how to conduct monetary policy under an inflation target.
During this period, the Riksbank made three changes to the inflation target. Most important, it
revised the monetary policy strategy in 2007/2008 by moving from inflation forecasting tointerest rate forecasting. In addition, it redefined the inflation target in 2010 and again in2017. None of these changes was related to financial stability; actually, the Riksbank
officially declared several times that financial stability was not a policy target for the Bank.

9https://www.scb.se/hitta-statistik/statistik-efter-amne/boende-byggande-ochbebyggelse/fastighetspriser-och-lagfarter/fastighetspriser-och-lagfarter/pong/tabell-ochdiagram/fastighetsprisindex-fastpi/
10
See Andersson (2017) for a discussion of the causes behind falling global interest rates.
9Interest rate forecasting
The policy strategy, introduced in 2007, originated from the work started within the Riksbank
in 2003 to improve its forecasting ability by developing a new general equilibrium model ofthe Swedish economy. 11 In this model, the assumption that the policy rate was constantthroughout the forecasting horizon was relaxed. Instead, the Riksbank forecasted the future
policy rate under the assumption that inflation would reach 2 percent by the end of theforecasting horizon. 12
In their review of the Riksbank, Giavazzi and Mishkin (2006) recommended that the
Riksbank shifted to interest rate forecasting. According to them, the previous assumption of a
fixed policy rate was an unrealistic assumption. This recommendation encouraged the
Riksbank to switch from inflation forecasting to interest rate forecasting.
The design of the Riksbank policy model effectively shifted the focus from inflation
forecasting to interest rate forecasting. By publishing the interest rate forecast, the Riksbank
expected to influence expectations held by capital market participants and by the public offuture rate changes. Thus, the interest rate forecast became a new and important tool for the
Riksbank. 13
The Riksbank published its first forecast of the interest rate path in 2007. Eventually, these
forecasts had a major effect on the monetary policy discussions among the members of theBoard, on the Riksbank’s communication with the public, and on the debate on monetary
policy in the media, creating new challenges for the Riksbank. Although the Riksbank made it
clear that the forecasted interest rate path did not constitute a promise binding the future
behavior of the Riksbank – but rather should be viewed as a forecast or educated guess –many viewed it as a forecast binding the behavior of the Riksbank. In addition, the uncertainty
surrounding the forecasts was rarely discussed.
Figure 6 illustrates some of the problems arising from the new interest rate forecasting
approach. The black line shows the actual repo-rate. The colored lines show the Riksbank’s
interest rate forecast published in the Monetary Policy Reports. The Riksbank forecasted theinterest rate path three years into the future. The forecast fell short in every single case. At
first, the forecast expected interest rates to return to the pre-crisis level of 4 to 4.5 percent. As
11

The Riksbank’s model RAMSES (since 2013 RAMSES II) is a dynamic stochastic generalequilibrium model (DSGE model).
http://www.riksbank.se/sv/Press-och-publicerat/Publicerat-fran-Riksbanken/Ovrigarapporter/Occasional-Paper-Series/2013/No-12-Ramses-II--Model-Description/
12
The monetary policy strategy is described in Riksbank (2007) as “[t]he Riksbank’s
forecasts are based on the assumption that the repo rate will develop in such a way thatmonetary policy can be regarded as well-balanced. In the normal case, a well-balanced
monetary policy means that inﬂation is close to the inﬂation target two years ahead without
there being excessive ﬂuctuations in inﬂation and the real economy”.
13
Jansson and Vredin (2003) examine the role of publishing central bank’s interest rate
forecasts.
10interest rates continued to fall, the forecast partly adjusted the forecasted interest path to alower level of 2 to 3 percent. When this also failed to materialize, the expected level was
reduced to less than 1 percent.
[FIGURE 6]
Forecasting future changes in the economy is difficult for two main reasons: First, no model isan exact representation of the actual economy. Second, unexpected future events that are bydefinition impossible to forecast will affect the outcome. Figure 6 illustrates that no model
could predict the unforeseeable. Instead, the models only predicted that the economy would
return to a path for growth, inflation and interest rates close to the average path in recent
years. The model’s predictions are only as good as the recent past is a guide to the future.
When the past is not a good guide, the model’s forecasts are of limited value.
Some members of the Riksbank Board apparently took the forecasts very seriously despite
flaws that became obvious over time. It is fair to say that they became prisoners of theforecasts and the econometric model behind them. In this process, their degree of freedom to
discuss policy issues became restricted by the interest rate path.
The review by Goodfriend and King (2016) brings out the disadvantages of interest rate
forecasting. They found that some members of the Board tended to be reluctant to change
their views on future interest rates for fear of contradicting the forecast path they had argued
for during the previous meeting, even when new information was available. The focus of thedebate shifted towards the interest rate forecast. As Goodfriend and King (2016, p 89) put it:“[t]here is something surreal about the precision of the guidance provided by individual board
members as to the future path of the repo rate when contrasted with the sheer uncertainty
about the future and the fact that markets took rather little notice of the published path indetermining their own expectations”.
It is trivial to say that all forecasts are uncertain. Still, some members of the Board argued forchanges to the forecasted interest rate path several years into the future of as little as a few
tenths of a percentage point. In this case, they displayed a strong belief in monetary policy
fine-tuning, in spite of the lack of basic power in the forecasts.

The Riksbank’s communication with the public
The switch from inflation forecasting to interest rate forecasting not only influenced thedebate within the Riksbank, but also had negative effects on the Riksbank’s communication
with the general public.
Before under inflation forecasting, the Riksbank communication strategy with the public wasrather simple. If the inflation forecast exceeded the inflation target, the Riksbank was
expected to raise interest rates, if the forecast fell short of the target, the Riksbank was
expected to reduce rates. With the interest rate forecast, communication turned into a more
complex discussion about confidence intervals and forecast uncertainty. The limitations of the11forecast approach were lost in the public debate. The Riksbank projected an image of being
able to forecast its policy rate several years into the future.
A second change that further complicated the Riksbank’s communication with the public was
the abolition of the tolerance band of +/-1 percentage point in 2010. The new inflation target
was defined as “close to 2 percent” inflation as measured by the CPI. In support for this step,
the Riksbank argued that CPI-inflation on several occasions had fallen outside the tolerance
band due to the repo-rate’s effect on mortgage costs of owner-occupied homes. To take one
case, in 2009, CPI-inflation was -0.3 percent, while CPIF-inflation was 1.7 percent. The
difference in inflation was the result of the aggressive interest rate cuts the Riksbank had
undertaken as a response to the financial crisis in 2008.
According to the Riksbank, “[t]oday there is considerable understanding for the fact thatmonetary policy is conducted under uncertainty and that inflation can from time to time
undershoot or overshoot the target. We at the Riksbank have long been careful to analyze andexplain such deviations from the inflation target. This has meant that the tolerance interval has
become obsolete” (Riksbank 2010).
The Riksbank hoped to gain greater flexibility by removing the tolerance band, but the effectturned out to be the opposite. Demands for the Riksbank to keep inflation exactly at 2.0
percent gained attention. Between 1995-2008, average inflation was 1.9 percent according to
CPIF, only 0.1 percentage points from the target. CPI-inflation was 1.4 percent during thesame period. This number was well within the tolerance band, but lower than CPIF-inflation
due to the Riksbank’s reduction of the repo rate that pushed down the cost of owner-occupied
homes in the CPI. The Riksbank had in other word succeeded in fulfilling its inflation target
as it was framed originally. Yet, some participants in the debate argued that deviations from
2.0 percent should be interpreted as evidence of a failure by the Riksbank to meet its target,
either by mistake or intentionally (see e.g. Svensson, 2015). 14 Those who claimed that the
Riksbank had failed to reach its target also argued for lower interest rates. The fact that lower
rates would have lowered CPI-inflation in the short term was lost in the discussion.
The combination of interest rate forecasting and the new inflation target without a band gave
rise to the “tyranny of the tenths”, according to deputy governor Henry Ohlsson (2016).
Rather than focusing on trends and a broad analysis of the economy, the Board, the media andthe public began to treat monetary policy as an exact science in which inflation was perfectly
measurable and controllable by the Riksbank. 15
As a response to the debate, the Riksbank reintroduced the tolerance band in September 2017,
now calling it the “variation band”, to “illustrate that monetary policy is not able to steer
14

While Svensson (2014, 2015) criticized the Riksbank for failing to hit the target of 2
percent, Andersson and Jonung (2014, 2015b) argued that the tolerance band should be taken
into account when evaluating the policy of Riksbank. Doing so, they found that average
inflation had been well within the tolerance band.
15
http://www.riksbank.se/PageFiles/56655/pro_penningpolitiskt_161220_eng.pdf
12

inflation in detail, but that inflation normally varies around the target” (Riksbank 2017a). At
the same time, the Riksbank changed the official price index used to measure inflation fromthe CPI- to the CPIF-index. The CPIF was already the Riksbank’s unofficial price index that
all their policy decisions and economic models were based on. Now it became the official
price index for the inflation target. According to the Riksbank, these two changes will notaffect the conduct of monetary policy. It is too early to evaluate their impact on the framing ofmonetary policy and on the communication of the Riksbank.
An important lesson from this period is that communication by the Riksbank with the media
and the public plays a crucial role in building or reducing trust in monetary policy. The public
easily understood the initial strategy of inflation forecasting based on a simple decision rule.
Inflation forecasting combined with an inflation target with an explicit tolerance band gave
the Riksbank sufficient flexibility to pursue a successful policy seen from the outside. The
shift to interest rate forecasting and to a new inflation target changed the picture, making thecommunication with the public too complicated and eroding public trust in the Riksbank.
Interest rate forecasting was based on three key but unrealistic assumptions i) that the
Riksbank could forecast its own future policy rate, ii) that the model used was an adequate
mapping of the actual economy, and iii) that the Riksbank had a more or less perfect control
over the macro-economy. None of these assumptions turned out to be well founded.

External shocks
The Riksbank faced additional challenges due to the 2008/09 global financial crisis and thedebt crisis in the euro area. The Riksbank responded rapidly when the financial crisis hit theworld economy in 2008. First, the Riksbank cut the repo rate from 4.75 percent in September
2008 to 2 percent in December and 0.5 percent in April 2009. Second, the Riksbank provided
liquidity support to commercial banks when international financial markets dried up following
the collapse of Lehman Brothers. 16 Overall, the policy was successful: no major Swedishbanks collapsed and the Swedish economy soon began to recover. Sweden surmounted theinternational financial crisis with only minor direct economic costs.
In 2010, real GDP surpassed the pre-crisis peak. CPIF-inflation was slightly above the target
in 2010, and the Riksbank began to tighten monetary policy. However, at this stage, the debt
crisis in the euro area and the slow recovery in the United States reduced inflation and growth.
As the Swedish economy recovered, the Riksbank began to increase interest rates to reducethe debt build-up in the economy. It soon became clear that increasing the policy rate in
Sweden at the same time as the Federal Reserve and the European Central Bank were
pursuing expansionary monetary policies by reducing their policy rates was extremely
difficult due to the openness of the Swedish economy (Ingves 2017). Capital started to flow
into Sweden due to the higher interest rates, and the krona exchange rate began to appreciate,hurting the export sector.
16

Molin (2010) contains a summary of the Riksbank’s emergency measures.
13

Inflation fell and economic growth declined, while employment continued to grow,consistently hitting higher levels throughout the period. Inflation below the target level
inspired criticism against the Riksbank for supposedly setting aside its inflation target
deliberately, in this way causing unemployment (Svensson 2015). This criticism, althoughhighly debatable (Andersson and Jonung 2014, 2015b), put pressure on the Riksbank. 17 It
contributed to a dramatic shift in policy in 2015, when the Riksbank established a negative
repo rate and initiated a Swedish quantitative easing program.
A monetary policy aimed at limiting the effects of the global financial crisis in the UnitedStates and the euro area became official policy in Sweden despite the Swedish economy
having escaped a domestic banking crisis. Monetary policy became expansionary at the time
the Swedish economy experienced high growth and record employment rates, thus
contributing to a pro-cyclical policy. 18 In other words, Swedish obtained a crisis policy
without a crisis.

Financial stability
The rapid expansion of credit flowed mainly to the household sector, which continued to takeon more debt. Higher rates interest rates during 2010-2012 stabilized household debt at 169
percent of disposable income, and put a short brake on real property prices (Figure 4). The
lowering of rates from 2013 onwards, especially the introduction of a negative policy rate,
fueled a new credit boom and subsequent increases in property prices (Figure 5). As
previously discussed, the price on tenant occupied homes soared by 45 percent between
January 2014 and April 2017 (Riksbank 2017b). CPIF increased by 4 percent during the same
period. Financial imbalances increased further, causing the Riksbank to warn against thesedevelopments while taking no action to address them.
Financial stability is one of the key historical responsibilities of a central bank (Goodhart
2010). The Riksbank’s reluctance to reduce the policy rate in 2012-2014 was partly due to afear of a credit-fueled boom. In 2013, however, the Swedish government decided to give
responsibility for financial stability to the financial supervisory authority, Finansinspektionen,
rather than the Riksbank. The Riksbank made it clear that it was going to focus solely on the
inflation target in spite of any negative effects such a policy might have on financial stability
in the long run.
17

Svensson (2015) based his criticism of the Riksbank on calculations of employment losses
using estimates of the Phillips curve. Andersson and Jonung (2015b) argued that Svensson’s
estimates were not robust as they suffered from several econometric problems. In addition, in
their opinion one-equation estimates are not sufficient to account for the wage-priceunemployment dynamics in an open economy like the Swedish one.
18
The employment rate reached 74.3 percent in 2008 before the financial crisis. It fell during
the financial crisis but began to recover in 2010. The employment rate reached its pre-crisis
level again in 2013 and has set new records thereafter. The employment rate in 2017Q1 was
76.8 percent, the highest since the early 1990s.
14

The Riksbank set a negative policy rate in 2015 and initiated a quantitative easing program
totaling 300 billion krona (approximately 7 percent of GDP). The effects on household debt
and property prices were large, as indicated by Figure 4 and 5. In recent years, the Riksbank
has frequently warned against financial imbalances, at the same time as it has contributed totheir build-up through an exceptionally expansionary monetary policy. The Riksbank (2017c)
signaled in 2017 that it was willing to make monetary policy even more expansionary, despite
the boom and the growing financial imbalances, to push inflation merely one or two tenths ofa percentage points higher. In our view, the inflation target initially introduced to increase
monetary stability turned during these years into a destabilizing force on asset markets.

2.4 A summary view of inflation targeting from 1995-2017
The Swedish monetary policy strategy under inflation targeting has evolved over time.
Several revisions of the target and the policy strategy have been undertaken. The relative
success of inflation targeting in the late 1990s and early 2000s probably contributed to a belief
that the Riksbank could fine-tune the economy with a high degree of precision. The policy
strategy from 2007 to 2017 was characterized by greater reliance on forecasts andeconometric models and a belief in the Riksbank’s ability to reach the target in due time.
The fact that Sweden avoided a deep domestic financial crisis in the wake of the global crisisof 2008 probably prevented this view from being challenged as in other countries. Crises are
the catalyst from which important policy reforms follow in Sweden (Andersson 2016, Jonung
2000). As Sweden avoided the worst effects of the global financial crisis, it also avoided
learning any new major policy lessons.
History shows that low inflation or even moderate deflation of consumer prices has no
significant effect on the real economy (Borio et al 2015). However, credit and asset pricebooms followed by asset price deflations and crises have severe negative economic andpolitical effects (Andersson and Jonung 2015a, Borio et al 2015). Recent financial
developments have demonstrated the dangers of a narrow focus on inflation targeting. The
future is likely to see further changes in the monetary policy regime. The present version of
inflation targeting is unlikely to be the final destination for the framing of Swedish monetary
policy (Jonung 2017).
A central lesson from recent monetary history is that financial stability does not automaticallyfollow from consumer price stability (Leijonhufvud 2007, Carney 2014, Smets 2013). A
debate has emerged on how to deal with financial stability. Should the central bank use theinterest rate to stem unsustainable credit booms or should financial stability be the task of afinancial supervisory agency, independent from the central bank, using macroprudential
instruments? If the latter approach is adopted, which policies should be used and what effects
will they have on the financial system and the economy? No consensus on these issues has so
far emerged.

15

3. Has inflation targeting been a success?
How successful is the inflation targeting policy of the Riksbank? The answer depends on how
success is measured. The Riksbank introduced an inflation target to reduce inflation following
the failure of fixed exchange rates throughout the 1970s and 1980s. Initiatives to reduce
inflation during the 1980s, for example the government’s announced inflation target in 1984,
failed due to a lack of credibility and the lack of appropriate policy tools (Feldt 1991). 19 The
Riksbank searched for an alternative regime when it was forced to accept a floating exchange
rate for the krona in November 1992. 20 At that time, inflation targeting turned out to be themost attractive option.
Low inflation was the overall aim of the inflation target in the 1990s. However, theexpectations concerning the benefits of an inflation target went further. Price stability was
also expected to bring about macroeconomic stability (Government Bill 1997/98:40), that ishigh and stable economic growth and financial stability.
Has inflation targeting delivered the expected performance? As a simple test, we compare theeconomic outcome during the inflation-targeting regime (1995-2016) with the two preceding
regimes: the Bretton Woods period (1951-1972) of fixed exchange rates, and the“accommodation” regime, when full employment was de facto the main goal despite a fixedexchange rate against either the Deutsche Mark or a basket of currencies (1973-1992).
Sweden had a fixed exchange rate but devalued the krona several times to maintain full
employment.
We evaluate the performance of the three regimes using five sets of indictors representing
monetary policy, fiscal policy, trust in monetary policy, real economic developments, andfinancial developments. Table 2 summarizes the results. The headline number shows theaverage outcome during the period and the number below in parenthesis displays the standard
deviation.
We use three measures of inflation to evaluate the success of monetary policy: CPI-inflation,
CPIF-inflation and the GDP deflator. CPIF-inflation is only available from 1987 and onwards.
CPI measures inflation in a selected set of consumer goods and services. The GDP deflator
measures prices of “everything” produced in Sweden. The deflator is thus a broader priceindex than the CPI.
Inflation targeting has clearly been successful in bringing down inflation and making inflation
less volatile. Average inflation was between 1.1 and 1.7 percent from 1995 to 2016,19

The government introduced an inflation target in 1984 while Sweden had a fixed exchange
rate, while lacking appropriate tools to implement the target. The policy consequently failed.
20
The search is reflected in a report by the Riksbank published in December 1992, containing
among other items accounts of the experience of floating exchange rates in New Zealand,
Canada and Switzerland (Riksbank 1992). See also Andersson (2003).
16depending on the inflation measure used. Inflation was slightly below 2 percent on average,
but well within the tolerance/variation band of +/-1 percentage point. Inflation was higher
both during Bretton Woods regime (between 3.8 and 4.0 percent) and during the full
employment regime (8.3 and 8.4 percent). Inflation volatility fell by as much as 50 percent
compared to the previous two regimes. Clearly, the Riksbank managed to control inflation
under inflation targeting.
With an inflation target and a flexible exchange rate, monetary policy becomes the main tool
to stabilize the economy. Fiscal policy is less potent in this case. A fiscal framework,
including an advisory fiscal policy council, was gradually introduced in the late 1990s and theearly 2000s to ensure long-term sustainable fiscal policies. Overall, fiscal policy, supported by
the new fiscal framework, has kept the government budget almost balanced (a small average
deficit of -0.1 percent of GDP) and a falling government debt-to-GDP-ratio since the mid1990s (Jonung 2015). This compares favorably to government deficits in excess of 5.3 percent during the full employment regime and a moderate deficit of 1.2 per cent during theBretton Woods era. 21
Table 2 thus suggests that fiscal policy has been synchronized with the inflation target, in thisway supporting the new monetary regime. 22 Likewise, the wage bargaining system in Swedenchanged in the late 1990s in a way that facilitated low wage agreements, a clear break withthe pattern of the 1970s and 1980s. In this way, nominal wage growth has been consistent
with the inflation target of 2 percent.
Trust in monetary policy is difficult to measure. Survey questions asking respondents about
their trust in the central bank are only available for the last ten to twenty years. An alternative
approach, developed by Fregert and Jonung (2008), is to rely on the length of wage contracts.
They derive trust in monetary policy by using the length and contents of collective wage
agreements. These contracts reflect the employers’ and the employees’ expectations about
future macroeconomic developments. If the social partners expect high and volatile inflation,
the length of wage agreements will be short and vice versa. The length of the wage
agreements is thus an indicator of the state of inflation expectations.
Trust in monetary policy has been the highest during the inflation-targeting period. Inflation
expectations have been at the lowest and most stable level. They have also been in line with
the inflation target on average, although as Figure 3 shows, they have varied over time as
actual inflation has fluctuated. The length of wage contracts has increased: the averagecontract length has been 2.8 years during inflation targeting, versus 1.75 years during theBretton Woods system and 1.46 years during the full employment regime.

21

The budget surplus is below the targeted level of 1 percent over the business cycle
according to the fiscal framework, but the fiscal situation has clearly improved compared to
the regime of accommodation.
22
Eklund (2003) argues that the new fiscal policy framework of the 1990s was a key
ingredient in the new stabilization framework alongside with the inflation target.
17

So far, the analysis clearly demonstrates that the inflation outcome has been better under
inflation targeting than under the earlier regimes. A less favorable picture emerges whenturning to real economic growth. On average, economic growth (GDP), growth in thestandard of living (GDP per capita), and productivity growth (GDP per hour) has been lower
under inflation targeting than under the Bretton Woods regime but higher than under the full
employment regime. The recent increase in growth relative to the 1970s and 1980s is notunique to Sweden. Most developed countries, irrespective of monetary policy regime,
registered a rise in economic growth during the 1990s and early 2000s (Andersson 2017). It istherefore difficult to attribute the increase in growth to the inflation target.
Unemployment has been higher under inflation targeting than in the previous two periods.
Unemployment has risen from an average of 2.0 percent during the Bretton Woods era to 3.1
percent during the full employment period to 7.8 percent under inflation targeting. Volatility
has also been higher for growth and unemployment. The effect of the 2008-09 financial crisis
increases the volatility. Removing the crisis years from the calculation reduces the volatility
numbers, but they still remain as high as during the full employment regime. In the UnitedStates, real economic volatility fell in the late 1980s (the Great Moderation). There was nosuch effect in Sweden. The conclusion is that, the inflation target has apparently not reduced
real economic volatility.
As discussed above, developments in the financial sector seem to be a major weakness of
inflation targeting. Long-term financial stability requires that the volume of credit and asset
prices in real terms do not to grow much faster than real economic growth for sustained
periods. During the Bretton Woods regime, credit to the private sector as well as share prices
expanded in line with real economic activity, while real house prices declined. Credit growth
accelerated during the full employment regime, exceeding real economic growth. This
contributed to the financial crisis of 1992-1993.
A few years of financial stability followed until the late 1990s, when a new period of credit
expansion and asset price inflation began. Real credit growth to the private sector and tohouseholds has grown on average by 5.5 and 5.9 per cent per year, respectively, under
inflation targeting. Real house prices have increased by 5.3 percent and real share prices by
9.3 percent, while average real economic growth has been 2.6 percent during these years. Low
interest rates are the major factor behind the rapid debt build-up and rising property prices,
although they are not the only cause of the rapid rise in house prices (Andersson and Jonung
2015a, 2016).
In hindsight, the process of financial deregulation in the second half of the 1980s had
profound consequences for the financial system. A most significant outcome of the
deregulation is the prolonged period of rapid expansion of the financial system, including
rapid growth or credit and asset prices, that continues up until today. This trend suggests thatan inflation target is not sufficient to avoid credit growth and asset price inflation getting outof hand.

18

Recently, calls for macroprudential policies to address financial risk have emerged. In
Sweden these policies have mostly aimed at reducing household borrowing. Whether thesetypes of credit controls will prove successful or lead to new unforeseen problems is still
unknown. So far, these policies have not limited the growth of household borrowing.

Summary
Has inflation targeting been a success? The answer is yes if we adopt a narrow focus on
consumer price inflation and inflation expectations held by the public. The answer is no if wetake into account real economic stability and financial stability. The real economy is no morestable or less stable than in the previous two regimes depending on whether the years aroundthe global financial crisis are included in the calculations or not. Credit growth and asset
prices have clearly outpaced real economic growth under inflation targeting. Real economic
and financial stability does not automatically follow from price stability.

4. Has the Riksbank exercised its monetary independence?
The Riksbank is an independent government agency free to make its own interest ratedecisions without political interference following the Riksbank law of 1998. The idea ofmonetary independence assumes that a central bank under floating exchange rate hasmonetary autonomy to set its policy rate solely according to domestic concerns. Formally, theRiksbank has the legal right to set any interest rate it chooses to reach its policy goals.
However, Sweden is a small open economy with free capital mobility. This openness may
reduce the Riksbank’s ability to set interest rates solely dependent on the state of domestic
economy. International influences may tie the hand of the Riksbank and make it reliant on thepolicy of larger central banks.
Here we consider the question to what extent the Riksbank has acted as an independent
central bank or followed the policy of two major central banks: the Federal Reserve, and theEuropean Central Bank (German Bundesbank before 1999).
Figure 2 suggests that the Riksbank has closely tracked the Bundesbank/ECB policy rate since1997. The Riksbank kept its policy rate above the German rate in 1995-96 but the exchange
rate appreciated. As inflation and growth declined, the Riksbank reversed its policy. Fromthen on, the average deviation between the Riksbank rate and the Bundesbank/ECB rate has
been zero.
There are potentially several causes behind the Riksbank’s choice to shadow the
Bundesbank/ECB. One potential explanation is that Sweden is a small open economy highly
integrated with the German/euro area economy. As the Swedish business cycle closely

19follows the European business cycle, the interest rate set by the Bundesbank/ECB will thus
also be the appropriate rate for Sweden.
Another potential explanation is that Swedish financial markets are highly integrated with
global financial markets. Swedish commercial banks increasingly rely on foreign debt tofinance their operations. In 2017, the four main banks had foreign debts outstanding
amounting to 175 percent of GDP, corresponding to 45 percent of all their debts (Riksbank
2017b).
Recent studies have shown that financial integration reduces the independence of national
central banks. Financial integration harmonizes credit flows, interest rates and asset prices
among countries (Andersson and Jonung 2016, Borio 2014). Any attempt to deviateconsiderably from international developments creates large financial flows that put pressure
on the exchange rate and thus spills over to the real economy and domestic inflation. Only
small deviations in the interest rate are thus sustainable (Rey 2013, Ingves 2017).
To illustrate the Riksbank’s dependence on international factors, we estimate the Riksbank’s
reaction function, i.e., how the Riksbank responds to developments in the Swedish economy
and in the global economy. The regression model is based on the Taylor rule, where thecentral bank sets its policy rate based on the domestic rate of inflation and the domestic
business cycle. We expand the model to take into account exchange rate movements, as they
are important for a small open economy, and we add variables representing the global
economy. These variables are policy rates, inflation and unemployment in Germany, andinflation and unemployment in the United States. 23
We estimate the following econometric model based on the Taylor rule:
𝑔𝑔𝑔𝑔𝑔𝑔𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑢𝑢𝑢𝑢𝑢𝑢∆𝑖𝑖𝑡𝑡𝑠𝑠𝑠𝑠𝑠𝑠 = 𝛼𝛼0 + 𝛽𝛽1 ∆𝑖𝑖𝑡𝑡−1+ 𝛽𝛽2 ∆𝑖𝑖𝑡𝑡𝐺𝐺𝐺𝐺𝐺𝐺 + 𝛽𝛽3 ∆𝑖𝑖𝑡𝑡𝑈𝑈𝑈𝑈𝑈𝑈 + 𝛽𝛽4 ∆𝜋𝜋𝑡𝑡−1+ 𝛽𝛽5 ∆𝜋𝜋𝑡𝑡−1 + 𝛽𝛽6 ∆𝜋𝜋𝑡𝑡−1+
𝑔𝑔𝑔𝑔𝑔𝑔𝑠𝑠𝑠𝑠𝑠𝑠𝑢𝑢𝑢𝑢𝑢𝑢𝑠𝑠𝑠𝑠𝑠𝑠𝛽𝛽7 ∆𝑢𝑢𝑡𝑡−1+ 𝛽𝛽7 ∆𝑢𝑢𝑡𝑡−1 + 𝛽𝛽8 ∆𝑢𝑢𝑡𝑡−1+ 𝛽𝛽9 ∆𝑒𝑒𝑡𝑡−1+ 𝜀𝜀𝑡𝑡(1)

where i is the central bank policy rate, 𝜋𝜋 is inflation, u is the unemployment rate (measuring
the business cycle), e is exchange rate index, 𝜀𝜀 is the error term, and ∆ denotes the absolutechange between two time periods. We assume that the Riksbank observes the US and German
policy rates when deciding the Swedish rate. As data on unemployment and inflation arecollected with a lag, we assume that the interest rate decision today is based on the interest
rate of the last quarter.
We estimate the model for the full inflation-targeting period from 1995Q1 to 2017Q2. We
also split the sample into two sub-samples, 2001Q1-2007Q2 and 2011Q1-2017Q2. These two

23

Most central banks use forecasts to set the policy rate. However, all forecasts made byeconometric models are based on available data and a forecast model. We can therefore use
the available data in the regression model instead of using central bank forecasts. See Stockand Watson (2002).
20

sub-periods are of equal size and about four years apart. The first sub-period corresponds tothe second period of Swedish inflation targeting, while the second sub-period corresponds tothe third period of Swedish inflation targeting as studied by us.
As a comparison, we include Iceland and Germany in the analysis. Iceland introduced an
inflation target in 2001 and Germany, as part of the euro area, adhered to an inflation target
throughout the period. Table 3 shows the results. A grey background implies that the variable
has a statistically significant effect on the interest rate decision of the central bank.
Global events clearly affect the Riksbank’s interest rate decisions in the full sample and in thetwo sub-samples. In the full sample, the German interest rate has a significant effect on the
Riksbank’s rate, as do German unemployment and Swedish inflation. Splitting the sample
reveals a change in the reaction function. In the first sub-sample (2001-2007), the Riksbank
responds primarily to the German business cycle. In the second sub-sample, the Riksbank
responds to interest rate changes by the ECB. A one percentage-point interest rate change by
the ECB leads to a 0.9 percentage point adjustment by the Riksbank.
Our results suggest that the Riksbank’s dependence on the ECB in the first sub-sample is theoutcome of synchronized business cycles between Sweden and Germany. The dependence inthe second sub-sample is probably due to financial integration of the Swedish economy into
the global financial system. Due to financial integration, the extreme monetary policy
undertaken by the ECB has been transmitted directly to Sweden. As previously discussed, theRiksbank’s attempts to set a higher policy rate more suitable for the strong Swedish economy
were eventually abandoned due to large financial flows and a pressure on the krona exchange
rate. 24
The Riksbank’s international dependence is not a binary variable where the Riksbank is either
fully dependent or fully independent. As Figure 2 shows, the Riksbank has chosen to deviate
from the Bundesbank/ECB rate by a few tenths of a percentage point on some occasions.
However, none of the domestic variables (Swedish inflation and unemployment) has any
significant effect on the Riksbank’s interest rate decisions. Only changes in the European
economy systematically trigger a response from the Riksbank.
[TABLE 3]
The Icelandic story is both similar to and different from the Swedish one. Icelandic interest
rates were highly influenced by US interest rates up until the financial crisis of 2008. Capital
controls introduced after the crisis reduced dependence on international developments. The
exchange rate also affected Icelandic interest rate during the first sub-period, where anappreciation leads to lower rates and vice versa. After the crises, only domestic inflation has

24

Ingves (2017) discusses why the Riksbank had to abandon an independent monetary policy
due to the record low European rates.
21

had a weak systematic effect on the central bank’s behavior. Interest rate decisions had nosystematic pattern during this period.
The ECB’s reaction function is markedly different from the responses of the Swedish and
Icelandic central banks. As the central bank for a larger currency area, the ECB is more
independent compared to both Sweden and Iceland. In the 2001-2007 period, the U.S. interest
rate had some influence on the ECB but the effect is weak. The euro area business cycle wasinstead the main driver of ECB interest rates. This effect was stronger in the second subsample when the effect of U.S. interest rates disappeared. We conclude that financial
globalization affects all countries, but a large currency area still has the ability to set an
independent interest rate suitable for the currency area. 25
Summary
The Riksbank is independent from the government, but not from the global economy.
International business cycle synchronization and deep financial integration have reduced the
Riksbank’s room to deviate from interest rates set globally. High domestic economic growthand growing financial imbalances suggest that Swedish interest rates should have been set
higher in recent years. Financial integration makes such an outcome very difficult as long as
the ECB carries out an expansionary policy based on extremely low policy rates. The ECB’s
policy to counter the financial crisis of 2008 and the debt crisis in the euro area has spilledover to Sweden in spite of the fact that Sweden did not experience a financial crisis.
Eventually, this may contribute to a future crisis in Sweden through increasing domestic
financial imbalances. 26

5. Monetary policy lessons from Sweden for Iceland
The economic policy debate often searches for the optimal policy that maximizes some formof utility or social welfare function. However, history shows that there is no optimal monetary
policy regime that survives the test of time. The economic landscape facing central banks isconstantly changing. Still, it is possible to draw a few policy lessons from recent Swedish
monetary experience that could serve as a guide to the monetary future of Iceland.
First, monetary regimes do not last forever. Rules-based regimes where the central bankadheres to the rules, such as the gold standard or inflation targeting, last longer than regimes
with uncertainty regarding the ultimate policy goal. The fixed exchange rate regimes of the
1970s and 1980s broke down because employment was the unofficial goal for stabilization
25

A common European monetary policy does not imply that the policy rate of the ECB is theproper one for every member state. The period leading up to the euro area debt crisis
demonstrates that interest rates were set too low for countries that later suffered from thebursting of the ensuing asset price bubbles.
26
Presently the Finansinspektionen is in charge of financial stability. We do not expect thisinstitution to be able to arrest the growth of credit within Sweden as long as the policy of the
Riksbank is expansionary.
22policy (Jonung 2017). Rules build trust by making policy predictable, which increases the
expected lifetime of the regime. This suggests a policy rule that makes policy transparent andthus easy to pursue, to track and to communicate to the public.
Second, policy learning is an ongoing process, often driven by the experience of economic
crises (Andersson, 2016, Jonung, 2000). The recent global financial crisis is one example ofan event leading to policy lessons around the world. However, in Sweden the international
financial crisis has had limited impact on the Swedish policy makers potentially because
Swedish did not suffer directly from the crisis. The Riksbank has maintained a narrow focus
on inflation targeting despite mounting evidence that its policy was creating growing financial
imbalances. This suggests that the policy regime adopted should be subject to regular
evaluations, preferably by a combination of foreign and national experts to improve policy
learning. In other words, rules are important but there should be escape routes from prevailingrules when sticking to them threatens macroeconomic stability in the long run.
Third, the Swedish experience of inflation targeting demonstrates that clear and constructive
central bank communication with the media and the public is an important prerequisite for a
successful monetary policy. The Riksbank shifted from inflation forecasting to interest rate
forecasting in 2007, and changed the inflation target in 2010 by removing the tolerance band.
These two changes created the impression that the Riksbank could forecast the near futurewith a high degree of certainty, and that it could reach the target of 2 percent through finetuning monetary policy. In this environment, small deviations in actual inflation from thetarget were taken as evidence that the policy of the Riksbank was failing. To restore trust in
the inflation target, the Riksbank turned to an extremely expansionary monetary policy in2015-2017. Improved communication concerning the Riksbank’s limited capacity to control
the rate of CPI-inflation in a small open economy as Sweden might have prevented the Bank
from going to such extreme measures.
Fourth, financial stability does not follow automatically from price (monetary) stability.
However, price stability requires financial stability. The Swedish experience demonstrates
that an inflation targeting policy that solely focus on price stability as measured by the CPIindex threatens to undermine financial stability in the long run. At this stage, it is not clear towhat extent macro-prudential policies such as leverage rules on banks and capital restrictions
can ensure financial stability in Sweden. However, such controls have likely unexpected andunintended effects. Households and firms usually find ways to avoid them. Macroprudential
instruments can serve as complements to the use of the policy rate to control a credit-fueled
asset price boom, but they are far from being full-fledged substitutes.
Fifth, the future is unknown and unpredictable. Monetary policy must consider thisuncertainty and cannot rely on models trying to predict the unpredictable. The shift to interest
rate forecasting has turned into a mistake. Inflation forecasting also suffered from similar
problems, but here forecasts were merely a guide for changes in the policy rate, not forpredicting the exact level of the future inflation rate.

23

Next, we will carry relevant parts of the above lessons from Sweden over to our discussion of
the proper choice of monetary regime for Iceland.

6. Alternative monetary policy regimes for Iceland
Which monetary policy regime is most proper for Iceland presently? To answer this question,
we start from the characteristic features of the economy of Iceland. These are the key to the
choice of the regime, as no policy regime is “optimal” for all countries, regardless of size,
trade patterns, geographical location, resource endowment etc. Next, we outline alternative
monetary regimes of interest for Iceland. Here we conclude that Iceland can choose from two
main sets of monetary policy regimes: a flexible exchange rate or a fixed exchange rate. In
Section 7, we discuss the costs and benefits of a flexible exchange rate and in Section 8 we
consider the costs and benefits of a fixed exchange rate. We conclude with a set ofrecommendations in Section 9.

6.1 Characteristics of the Icelandic economy
Iceland is a small economy with about 335,000 inhabitants, located at the periphery of the
global economy. The Icelandic krona (ISK) is the smallest currency in the world supplied byan inflation targeting central bank, the Central Bank of Iceland (CBI). Iceland has a highly
volatile monetary and financial history. Periods of high growth have mixed with periods ofsevere economic recessions. Recently, Iceland suffered from one of the greatest financial
disasters experienced by a rich country, classified by some as the biggest crisis of all. 27
The domestic financial market is limited, implying that the government cannot rely on
domestic sources to finance any prolonged period of public deficits. Iceland is also an open
economy and thus subject to shocks from the world economy. The economy relies on a few
export items. Fish used to be the staple export; later aluminum and most recently tourism havebecome the most important sources of foreign currency. Almost all other goods, from cars tofood, are imports.
There are clear diseconomies of scale due to the small size of the Icelandic economy. 28 The
restricted domestic market limits specialization. This means that Iceland must turn to foreign
markets to reap the benefits of specialization, making the economy vulnerable to changes inexternal conditions. It also makes the exchange rate an important economic variable. Smallchanges in the exchange rate have large effects on economic welfare.

27

There are numerous accounts of this financial disaster. See, e.g., the contributions in Aliber
and Zoega (2011) for the run-up to the crisis, Gylfason et al. (2010), Gylfason (2015) andJónsson and Sigurgeirsson (2016) for an analysis of the Icelandic boom-bust pattern.
28
See Gylfason (2009).
24

Another negative consequence of smallness concerns the quality of governance by the public
sector. The record of economic policymaking in Iceland, not least from the recent financial
crisis, suggests that close ties between business groups and politicians in power have had an
unduly influence on policy outcomes . 29 On the other hand, Iceland is exceptional in the sensethat a number of bankers have received jail sentences, although it is an open question to what
extent major culprits have been able to evade prosecution.
Being small also may have some advantages. For example, the public’s preferences may moreeasily be reflected through the political system in a small country than in a large one. The
volatile political performance of Iceland in recent decades lends mixed credence to this view.
Smallness may invite economic as well as political instability. To sum up, the choice of theregime for Iceland must be based on the fact that Iceland is a very small open economy,
heavily reliant on foreign trade.

6.2. Choosing the monetary regime
All monetary regimes have an international and a domestic aspect. The international aspect
relates to how the value of the domestic currency is set in relation to other currencies of theworld, and whether capital can flow freely across borders. The exchange rate can be flexible,
allowing the market to set the value of the currency, or fixed (pegged), whereby the value
against another currency, a basket of currencies or a commodity such as gold is determined by
the central bank or the government. 30 The domestic aspect relates to the role of the central
bank in the domestic economy: should the central bank try to influence domestic outcomes or
be passive? The design of monetary policy depends on international arrangements, i.e., on the
choice of a fixed or flexible exchange rate and whether capital restrictions are used or not.
In other words, the first step when determining the goal for monetary policy is to determine
the exchange rate regime. In principle, Iceland has a menu of regimes to choose from, assummarized by Table 4. Each of the two major regime arrangements, fixed and flexible, isbroken down into sub-sets reflecting, in the case of fixed exchange rates, the extent to which
the rate is fixed, and in the case of flexible rates the possible domestic policy goal. It is
possible to decide on a combination of regimes if capital restrictions are in force. Some of theregime options in Table 4 are currently in use, most prominently monetary unions, currencyboards, various fixed exchange rate arrangements and inflation targeting. Others have existed
in the past, such as the gold standard. Economists have also proposed additional regimes notincluded in Table 4.
Which regime in the catalogue of different regimes in Table 4 promises the best economic
performance for a country like Iceland? The theoretical literature does not provide a clear
answer. No optimal monetary regime can be derived from economic theory. However, theory
29
30

See Sibert (2011) and Gylfason (2015).
We use the term pegged as a synonym for fixed in our discussion of exchange rate regimes.
25

and history offers a few guidelines: First, rules-bound policy regimes provide greater
economic stability. Second, the regime has to be credible. Third, monetary policy alone
cannot provide economic stability. Fiscal policy and the behavior of the private sector also
matter. For example, weak public finances or excessive wage claims can threaten the stabilityof any monetary policy regime. The reason credible and rules-based regimes are more
successful is that the government and the private sector have aligned their behavior according
to the rules of the regime. Their behavior thus indirectly supports the policy of the central
bank and makes it easier for the central bank to reach its target.
Swedish monetary history as outlined above supports these arguments. Rules-based systems
have lasted longer and regimes that lacked credibility. The fixed exchange rate regimes of the
1970s and the 1980s collapsed when labour unions demanded wage increases that underminedthe competitiveness of Swedish exports. 31 The recent success of inflation targeting in Sweden
is largely explained by fiscal policy and collective wage agreements being consistent with the
inflation target.
Our conclusion is that whatever regime Iceland chooses, it should be rules-based, credible,
supported by the government through its fiscal policy and accepted by the general public asreflected in wage agreements consistent with the regime.

6.3 Alternative monetary regimes
Since the 1960s, economists have discussed the choice of regime starting from the monetaryor macroeconomic trilemma. The trilemma states that among the three policy goals of a fixedexchange rate, free capital flows and monetary independence, no more than two goals are
fully achievable at once. 32 A fixed exchange rate and free capital flows form a common
combination in economic history, with the classical gold standard as a prime illustration.
Monetary independence and free capital movements is another possible combination;
presently inflation targeting is the principal example. However, monetary independence isincompatible with a fixed exchange rate, unless there are controls over cross-border capital
flows.
In recent decades, researchers have challenged the classic trilemma framework. Rather than atrilemma, they argue that financial globalization has reduced the problem to a dilemma given
the scale of global financial markets and financial integration in recent years. 33 The only
choice is between monetary independence through capital controls or monetary dependence
31

Bordo and Jonung (1997) survey the empirical evidence from different monetary regimes ina historical context.
32
The trilemma can be traced back to the Mundell-Fleming approach developed in the 1960s.
It received considerable attention in the debate concerning optimal currency unions and thecommon European currency. Work in the 1990s gave empirical support to the trilemma. See
Obstfeld and Taylor (2017) for a current review.
33
See for example Rey (2013).
26

through no capital controls. This argument is supported by our analysis in Section 4 of thedeterminants of the policy rate of the Riksbank. 34
In short, the monetary autonomy of countries on a floating exchange rate that are financiallywell integrated is limited – although it is an open question how limited. The main channel
limiting autonomy is the co-movement of interest rates across countries regardless of theexchange rate arrangement. Here, the Federal Reserve and the ECB hold a key role because of
the sheer volume of financial assets denominated in dollars and euros, and thus depending on
US and euro interest rates. As the analysis in Section 4 demonstrates, changes in the Federal
Reserve or the ECB rate automatically spreads to smaller economies through financial
linkages. Consequently, small countries like Sweden or Iceland with floating rates and withfree capital mobility cannot isolate themselves from the monetary policy decisions made by
the Federal Reserve and the ECB.
The policy conclusion is straightforward. If a country wants to keep its domestic monetary
independence, even when adhering to a flexible exchange rate, it must consider measures tomanage and restrict the flow of cross-border credit. However, such restrictions come with acost; they are likely to reduce long-term economic growth. Without such restrictions, thecentral bank will be forced to shadow the interest rate path chosen by the major central banks,irrespective of the state of the domestic economy – as demonstrated by the case of the
Riksbank in recent decades.
The first step is therefore to decide on open or closed borders for capital mobility. Given thelimited size of the Icelandic economy and of its domestic financial markets, we recommend
open capital markets. Closed capital markets would likely reduce economic growth in thelong run. However, the central bank or some other government authority should have tools at
its disposal to limit international financial flows if these flows threaten to destabilize thedomestic economy (Rey 2013). 35 The second step is to choose between a flexible exchange
rate and a fixed exchange rate. In Section 7, we discuss possible regimes based on a flexible
exchange rate and in Section 8 possible regimes based on a fixed exchange rate.

7. A flexible exchange rate for IcelandWith a flexible exchange rate, a country like Iceland can adopt a number of monetary
regimes. It can target the price level, the wage level, nominal GDP or the rate of inflation tomention some alternatives. We focus our discussion on inflation targeting as such a regime
holds a central position in present debate on monetary policy.

34

See e g Obstfeld and Taylor (2017).
The exact tools used depend on the situation and the structure of the financial system. How
effective full capital controls are in stabilizing the financial system and the economy is an
open issue (see, e.g., Klein 2012). However, given the recent experience of destabilizing
financial flows, the potential use of capital controls should not discarded (Rey 2013).

35

27

7.1 Should Iceland target inflation?
Most central banks in countries with flexible exchange rates have adopted an inflation target.
Iceland is no exception. It has an inflation target of 2.5 percent, which the CBI adopted in
March 2001. The target has a tolerance interval of 1.5 percentage points, and the central bankmust communicate with the government explaining actions undertaken to return inflation if it
falls outside the tolerance interval. The Icelandic inflation target is stricter than the Swedishtarget. The Riksbank is concerned about inflation, but also to some extent about growth. The
CBI only considers other macroeconomic variables when taking its interest rate decisions
when inflation is within its tolerance band. 36
As already discussed, for a small country a strict inflation target is only feasible with some
restrictions on international capital flows. The Swedish policy of deviating from the German
policy rate in 1995-96 as well as in 2011-12 was quickly reversed. Sweden has in practice
behaved as a country with a fixed exchange rate, as illustrated by the policy of shadowing theBundesbank/ECB interest rate since 1997. In a recent speech, Stefan Ingves, head of the
Riksbank, talked about “the elephant in the room”, where the elephant is the euro. The
Riksbank has tied itself to this elephant (Ingves 2017).
Iceland is in a similar situation as Sweden, although still more exposed to international events
due to the small size of its economy. Between 1995 and 2007, the CBI interest rate displayed
the same movement as the Federal Reserve rate, confirming the results from our previous
regression results. However, the Icelandic interest rate was persistently higher than the US
interest rate (Figure 7). The higher Iceland interest rate was inspired by a relatively highinflation (Figure 8). Inflation was on upward trajectory from 2003 to 2008.
[FIGURE 7][FIGURE 8]
The rules of the inflation target dictate that to suppress inflation, interest rates should risewhen inflation is high. For Iceland, inflation moved in the opposite direction. In response tohigher domestic interest rates, commercial banks, firms and households on Iceland started toborrow from abroad in foreign currencies at lower interest rates, bringing capital into Iceland.
Foreign actors entered as well, purchasing ISK-denominated assets offering higher returns
than the global average, financing these purchases by borrowing in markets with low interest
rates (the “carry trade”).
The interest-rate differential between Iceland and the rest of the world contributed, at an
initial stage, to an inflow of capital, an appreciating ISK, a rapidly expanding domestic moneystock and credit volume, rising domestic inflation and rising asset prices. This process
36

https://www.cb.is/monetary-policy/inflation-target/declaration-on-inflation-target/28

continued until the beginning of the international financial crisis in 2007/08 when the
Icelandic krona began to lose value despite a growing interest-rate differential with the rest of
the world. The appreciation had positive wealth effects, encouraging rising consumption andrising imports. The Icelandic exchange rate also appreciated, which fueled an increase in
consumption of imported goods.
The commercial banking system expanded at an unprecedented scale: compared to the GDP
of Iceland it grew from 170 percent in 2003 to 562 percent by 2006 and further to 971 percent
in 2008. 37 A large part of the increase in lending from the Icelandic banks took place in othercountries than Iceland, but domestic credit also expanded rapidly. Iceland’s membership in
the European Economic Area (EEA) gave access to European capital markets that made theincrease in lending possible. This process gave rise to the idea that Iceland was turning into aninternational center for finance. 38
Given the framework of inflation targeting, the response of the CBI was to raise the policy
rate in the hope that a higher policy rate would put a brake on inflation. However, theoutcome was the opposite. It contributed to a cumulative process where higher interest rates
gave rise to a monetary expansion, not a contraction, and to higher inflation rather than lower
inflation.
In short, inflation targeting fueled a highly unstable dynamic process: higher policy rates by
the CBI lead to higher asset price, greater private consumption, higher inflation, and higher
interest rates. The outcome was growing financial imbalances. Eventually, the process cameto a sudden stop. Iceland experienced a deep financial crisis starting in 2007 and peaking in
the fall of 2008.
The inflation target and the policy pursued to reach the target was the main factor behind thiscatastrophic outcome. 39 Since the crisis, Iceland has returned to a policy of inflation targeting,while relying on capital controls and macroprudential tools, so-called “inflation targetingplus”. 40 The gray area in Figure 8 illustrates the period with capital controls. Inflation
targeting plus has successfully brought inflation down and stabilized it at around 2 percent.
However, it is an open question if the CBI will be able to stabilize inflation in the future now
that capital controls have been largely abolished – a step taken in early 2017. Comparing the
inflation outcome between Sweden (Figure 1) and Iceland (Figure 8), we see that from 2014
onwards inflation has been more stable in Iceland compared to Sweden. To what extent thedifferences is due to capital controls is uncertain, but it is likely that the controls haveincreased the CBI’s ability to control inflation in Iceland.

For data on credit see https://www.sedlabanki.is/hagtolur/hagtolur.
See various contributions in Aliber and Zoega (2011).
39
See for example Danielson (2008) on the role of the targeting regime of the CBI.
40
Capital controls have been lifted over time and were largely abandoned by early 2017,
although some restrictions remain. See Central Bank of Iceland (2017) for an assessment of
the inflation targeting framework of Iceland before and after the crisis of 2008.
37

38

29

To sum up, inflation targeting does not allow a small country such as Iceland to carry out afully independent monetary policy without risking grave challenges. In the present globalized
world, full monetary policy independence for Iceland requires capital restrictions, judging
from Iceland’s own recent experience.
An alternative to a specific numerical value for the inflation target is an inflation range. In thiscase, the central bank does not aim for an exact inflation number but rather it tries to holdinflation within a given range, e.g., within 0 to 4 percent inflation – a range suggested for
Sweden by Andersson and Jonung (2017b). By targeting a range rather than a number, thecentral bank obtains some additional degrees of freedom to set the interest rate based on thestate of the domestic economy. However, the increased freedom is still limited by free capital
movements across borders.
To conclude, without permanent capital controls – which have negative long-term effects on
economic growth – Iceland cannot pursue an independent monetary policy and achieve an
inflation target. 41 For this reason, we recommend that Iceland should not opt for a flexible
exchange rate.
Let us now turn to a fixed exchange rate arrangements in our search for a better alternative.

8. Fixed exchange rate arrangements
There are several types of fixed exchange rate regimes (Table 4). The different regimes arecharacterized by how easy it is to adjust the exchange rate. Membership in a monetary union
represents one extreme, with very high costs for changing the rate. A fixed but adjustable rate
against a foreign currency is the other extreme, where the cost of changing the rate isrelatively low. With a currency board, it is easier to adjust the rate than in a monetary union
but harder than with an adjustable fixed rate
Each stable exchange rate regime has some unique characteristics. However, they also sharesimilar advantages and disadvantages compared to a flexible rate arrangement. Before
discussing types of stable exchange rates, we consider their common advantages anddisadvantages compared to a flexible rate.
A stable exchange rate facilitates foreign trade, contributing to higher economic growththrough greater specialization. The framing of monetary policy becomes a simple task.
Theoretically, with a flexible exchange rate the central bank sets the interest rate dependent on
the state of the economy. This requires an advanced analysis of the state of the economy todetermine what the appropriate interest rate level is. With a stable exchange rate, the central
41

Even large countries such as the United States and the euro area have for long periods failed
to reach their inflation targets. This suggests that inflation targeting in its present form hassome major weaknesses.
30

bank’s work is limited to maintaining the fixed rate by shadowing the international interest
rate.
A disadvantage of a stable exchange rate is that the exchange rate cannot act as a buffer
against economic shocks. A flexible exchange rate may at least partly insulate the domestic
economy from some of the effects of a either a domestic or an international economic shock.
With a stable exchange rate, all adjustments for restoring stability from a shock must comewithin the domestic economy. The stable exchange rate thus requires that domestic prices andwages be flexible to be viable.
Relying entirely on wage and price adjustments can be difficult, especially if prices and wages
are sticky and change slowly. It can also be necessary to use fiscal policy to counter a
temporary economic shock. The government thus needs fiscal space to be able to stimulate theeconomy during a recession and the political strength to reduce demand during a boom.
The strengths and weaknesses of a stable exchange rate are illustrated by Figure 9, whichshows an index of the real exchange rate for Denmark, Finland, Norway and Sweden between
1983 and 2017. The record of Iceland is depicted in Figure 10. The real exchange rate is
calculated using the nominal exchange rate and the average unit labour cost. The index thus
illustrates the country’s labour cost in relation to its trading partners. An increase in the index
implies that domestic wage costs have increased and a reduction implies that the domestic
wage cost has decreased. The index takes the value 100 in 2000Q1.
Denmark is an example of a country with a fixed exchange rate throughout the period.
Finland had a fixed rate 1983-1992 and joined the euro in 1999. Sweden had a fixed rate until
1992 and a flexible rate thereafter. Norway had a fixed rate until 1992, a semi-fixed until
2001 and a flexible rate with an inflation target thereafter.
[FIGURE 9]
The Danish real exchange rate has shown moderate fluctuations throughout the period, butthere is no trend upwards or downwards. The boom in the 2000s led to an appreciation of thereal exchange rate by close to 10 percent. It took Demark about five years to restore the realexchange rate to the pre-boom level through wage restraint. Thus, average Danish wage
growth has been close to the average among its trading partners. In this way, Danish labour
market participants have aided the central bank in stabilizing the exchange rate by not puttingpressure on it through rapid wage inflation. 42 This was not the case in Sweden and Finland
during the 1980s, where wage inflation eroded competitiveness and forced devaluations of theexchange rate in 1992.

42

Likewise, Danish fiscal policy has played a crucial role in creating credibility for theDanish exchange rate peg. See Andersen and Chiriaeva (2007).
31

Wage inflation in Finland and Sweden was partially the outcome of an uncontrolled domestic
economic boom. Lack of confidence in the central banks’ commitment to the fixed rate
contributed to wage inflation. Finish developments after Finland joined the euro mirror theDanish experience. Wage increases in Finland have been close to the average of its trading
partners and Finland’s competitiveness has experienced only minor variations.
Swedish wage growth has also been close to the international average and the Swedish
nominal exchange rate versus the euro or the dollar shows no trend upwards or downwards.
However, there have been prolonged deviations from the average rate (Andersson 2014).
During international recessions such following the dot-com bubble in 2000 and theinternational financial crisis in 2008/09, the Swedish krona has lost in value. The realexchange rate has thus depreciated, in this way supporting economic growth in Sweden. Most
noteworthy, the depreciation in 2009 facilitated recovery of the Swedish economy.
Norway stands out from the other Nordic countries for a major appreciation of the realexchange rate from 2001 until 2012. The appreciation was partly caused by a high central
bank interest rate, above the ECB rate, and rising prices for oil, Norway’s main export. Theboom in the oil sector raised nominal wages. Part of the increase in the real exchange rate wasdue to wage inflation, although the major part of the rise was due to an appreciating realexchange rate. Normally, an appreciating real exchange rate slows down the economy, but theboom in the oil sector was too strong to be offset by the appreciating real exchange rate. A
slowdown in the oil price and lower Norwegian interest rates have caused a deprecation since2012. The large swings in the real exchange rate clearly have had a negative impact on nonoil exports. Norway’s’ experience also illustrates that the exchange rate in itself is insufficientas economic regulator.
Iceland experienced a similar appreciation of the real exchange rate following the introductionof the inflation target in 2001. The appreciation ended in 2008 (Figure 10) and was followed
by a steep depreciation in 2008-2009 and another period of appreciation from 2014-2017.
Figure 10 also shows the exchange rate between the ISK and the US dollar and the ISK andthe euro. These exchange rates are measured as an index (2000Q1=1000). A higher index
number implies a stronger ISK. From 2000 to 2010, most of the variation in the real exchange
rate index is due to variations in the nominal exchange rate (especially against the US dollar)
and to a lesser extent due to high wage claims. Since 2014 there has been a wage-driven
recovery of the real exchange rate in Iceland. As in Norway, changes in the nominal exchange
rate have been insufficient to stabilize the domestic economy. Still, the depreciation of thereal exchange rate clearly aided the recovery from the financial crisis.
[FIGURE 10]This analysis reveals that a central bank needs the assistance of the private sector to maintaina stable exchange rate. The Danish case also illustrates that a country where both policy
makers and the public are committed to the fixed exchange rate can maintain the rate overlong periods. It is especially important that the labour unions support the exchange rate policy
32

in a country with a high unionization rate. This support was largely lacking in Sweden during
the 1980s, in contrast to Denmark, where the public and policy makers have backed up thepolicy. 43
The analysis based on Figure 10 demonstrates that the adjustment process following a sharp
rise in the real exchange rate can take a long time if it relies solely on wage restraint.
Additional policies can facilitate the return to a stable economy when the possibility to adjust
the exchange rate is not available. Fiscal policy can reduce the pain of adjustment. However,it requires fiscal space to run major deficits in a recession. A system of buffer funds is anotherapproach. 44 45 During normal times, buffers can be created to be used during downturns tostimulate the economy. Several states in the United States have established “rainy day funds”
to stabilize their economies.
For a small country such as Iceland that relies on a few export goods, buffering against
fluctuations in foreign demand may be crucial. A shock to one sector can easily cause
destabilization of the entire economy. Iceland should examine the option to establish
stabilization funds or buffer funds if it considers a fixed exchange rate. To avoid politicalinterference, such a system of buffering should be designed as an automatic system that
increases and decreases taxation based on observable indicators of economic performancesuch profit shares, exports, wages and the unemployment rate. Buffer funds may serve as
automatic stabilizers during downturns without creating large budget deficits. The exact
construction of such funds, which taxes to alter, the size of the variations in taxes and theexact mechanisms that triggers a change in taxation, requires a thorough analysis.
To sum up, to obtain the full benefits of a stable exchange rate, the private sector must support
the exchange rate regime by acting according to its implicit rules. Stabilization funds in one
form or another could help against large swings in international demand.

8.1 Should Iceland adopt a fixed but adjustable exchange rate?
A fixed but adjustable exchange rate was the dominant exchange rate arrangement from the
Bretton Woods period until the introduction of the euro. With growing financial openness, thepopularity of fixed rates declined significantly. Financial crises contributed to the decline,
43

Germany during the international financial crisis in 2008-2009 is an example of labour
union support for the monetary policy regime is. The relatively quick recovery of the German
economy after the crisis is partly accredited to the behaviour of the unions (Möller 2010 and
Burda and Hunt 2011). In Sweden, the labour market participants reached an agreement thatfacilitated adjustment to the same crisis.
44
The Finish buffer funds served as an inspiration for the Swedish labour unions in the
Swedish referendum on joining the euro in 2003. The labour union movement demanded theestablishment of similar funds to buffer against booms and recessions as a prerequisite forjoining the euro.
45
See OECD (1998).
33

prompting many countries to abandon their fixed rates. Today fewer than 60 per cent of all
countries are on a fixed rate arrangement. 46
Scandinavia provides two interesting observations here – one a failure and one a success.
Sweden had a pegged exchange rate in the 1970s and 1980s. Sweden devalued on several
occasions to preserve the competitiveness of Swedish industry during these decades. Afterfinancial deregulation in the second half of the 1980s and an ensuing credit boom, Sweden
suffered from speculative attacks on the krona. Eventually, the Riksbank replaced the fixedexchange rate by a floating rate. Norway and Finland followed a similar path. 47 On the other
hand, Denmark has maintained its fixed rate since 1982. There have been sporadic speculative
attacks on the Danish currency, but to no avail. 48
We do not recommend Iceland to follow the Danish approach of adopting a fixed rate to theeuro at this stage. Such a step would require a degree of credibility that Iceland does notcommand. Financial markets are well aware of the volatile history of the Icelandic currency.
As Iceland is much smaller than Denmark, the resources needed to maintain a credible peg for
the ISK would come at a much higher price than for Denmark. A fixed ISK would eventually
be the subject of speculative attacks – in particular in the absence of Icelandic capital controls.
The welfare costs to Iceland of a pegged but adjustable rate would be higher than any
conceivable benefits.

8.2 Should Iceland become a member of a monetary union?
A monetary union is a geographical area within which only one type of currency circulates asmoney that serves as the unit of account, the medium of exchange, and the store of value.
Within a monetary union, the exchange rate is by definition irrevocably fixed – unless acountry reverts to a new domestic currency. Introducing a new currency, however, is bothdifficult and costly.
All the members of a monetary union are using the same currency or the same currencies tied
to each other at locked rates. Vis-à-vis the rest of the world, a monetary union has one
exchange rate for converting outside currencies into the common currency.
For a country as small as Iceland, membership in a monetary union would offer several
benefits. First, it would facilitate international trade within the monetary union to which
Iceland belongs. Second, joining a monetary union would be a way to import monetarystability from the common central bank, fostering macroeconomic stability presuming that thecommon central bank has a credible policy. Third, membership in a monetary union would46

See Figure 4 in Obstfeld and Taylor (2017).
See Jonung et al (2009).
48
See Gylfason et al (2010).
47

34

give Iceland access to international financial markets without the exchange rate risk that an
independent currency involves. 49
These main benefits should be compared to the costs of membership in a monetary union. The
prime cost is the loss of an adjustment mechanism. Without a domestic currency, there is no
exchange rate to offset the effect of large external shocks. Nor is there an escape clause thatwould allow the country to leave the union if the membership of the union destabilizes the
economy. Adjustments of prices and wages in relation to other countries necessary tomaintain international competitiveness are only achievable through flexible domestic wages
and prices. Domestic rebalancing can be both difficult and time-consuming, as the experienceof the euro area periphery since 2008 illustrates. In Greece, Italy and Portugal prices, wages
and living standards have fallen as these economies have regained their economic balance
after the financial crisis and the debt crisis. Ireland has fully recovered, but only after
suffering several difficult years.
Much of the balance between the benefits and costs of a monetary union hinges upon theimportance of having a flexible exchange rate serving as a shock absorber. For a country like
Iceland, its monetary history serves as a guide here. As domestic monetary policy in Icelandby tradition has been a source of shocks, this tips the balance in favor of tying the hands of thedomestic monetary authorities.
The euro area and the dollar area (the United States) are each an economic and a politicalunion. However, a country can belong to a monetary union without belonging to a politicalunion. In Europe, four small countries (microstates), Andorra, Monaco, San Marino and the
Vatican City, use the euro without belonging to the European Union. In addition,
Liechtenstein uses the Swiss franc without being in a political union with Switzerland.
Several countries in Europe like Albania, Croatia, the Czech Republic and Serbia havewidespread use of the euro alongside the national currency. Montenegro and Kosovo are
euroised. 50
For Iceland, there are two possible monetary unions to join, the euro area or the dollar area.
The choice is thus between euroisation and dollarisation. The euro is a common currency forinvoicing Icelandic exports and imports and is the currency for financial reporting of major
export companies as well. This process of euroisation is simple to explain. The EU is the main
trading partner of Iceland. 51 Iceland is already a member of EEA (the European EconomicArea) and the Schengen area. It is fair to say that Iceland is already a partial member of theEU.

49

Iceland was once a part of the Scandinavian currency union (SCU) because of being under
Danish rule. The SCU functioned as a successful monetary union from the early 1870s until
the outbreak of World War I (Jonung 2007), providing Iceland with the benefits of being amember of a monetary union.
50
See Winkler et al (2004) and ECB (2017).
51
The determinants of euroisation are examined in ECB (2017).
35

The other Nordic countries, with the exception of Norway, are also geared towards the euro.
Denmark has a fixed exchange rate to the euro. Sweden is more or less shadowing the euro, asseen from our previous account of the policy of the Riksbank. Finland and the Baltic countries
are euro members. For these reasons, adopting the euro as the currency of Iceland would be
more attractive than adopting the dollar.
The adoption of the euro can take the form of either a bilateral (or official) agreement or aunilateral decision. A bilateral route likely implies full membership in the EU. In that case,
Iceland may influence monetary policy decisions in the euro area. However, the influence
would be small given the size of the Icelandic economy. Joining the EU as a full member
would be a very political and time-consuming decision that Iceland does not appear to beready to take in the near future.
In our view, the most constructive route for Iceland at this stage is to settle for a unilateralapproach. A number of steps to increase the domestic demand for euros can be considered.
The Icelandic authorities could gradually introduce the euro as a parallel currency. 52 The euro
could even be adopted as legal tender within Iceland at the going market exchange rate.
Employers could be encouraged to pay wages in euros and the capital account could be madecompletely open for transactions in euros. In this way, European commercial banks may feel
more welcome to enter Iceland, a country still lacking in presence of foreign-owned
commercial banks.
We recommend that such a unilateral route – if taken – should be combined with contacts andan exchange of information with the ECB and the EU. 53 We expect the ECB and the EU to bepositive towards an increasing use of the euro by Iceland.
Competition between the two currencies, the euro and the ISK, would likely have a positive
impact on the performance of the CBI. Eventually, Icelandic coins and notes could easily beconverted to euros and taken out of circulation at the going exchange rate. The process can bea gradual one but once it has picked up speed, the actual transformation into the euro area canbe rather short in time.
As discussed in the next section, the advantages of a membership in a monetary union
discussed above can be obtained by a currency board arrangement for Iceland.

8.3 Should Iceland set up a currency board?

52

The use of parallel currencies is common historically. For example, along the border
between Canada and the United States, US dollar and Canadian dollar both circulate although
US dollars dominates on the US side and Canadian dollars on the Canadian side. Businessestablishment accept both currencies.
53
For the institutional factors concerning euroisation, see ECB (2017).
36

A currency board is a form of a monetary union. It “issues notes and coins convertible into aforeign “reserve” currency at a fixed rate and on demand. It does not accept deposits. As
reserves, a currency board holds high-quality, interest-bearing securities denominated in thereserve currency. A currency board’s reserves are equal to 100 per cent or slightly more of its
notes and circulation, as set by law. (Commercial banks in a currency system need not hold
100 per cent reserves in reserve currency. The board generates profits (seigniorage) from thedifference between the interest earned on the securities that it holds and the expense ofmaintaining its notes and coin circulation. It remits to the government or to another institution
all profits beyond what it needs to cover its expenses and to maintain its reserves at the levelset by law. The currency board has no discretion in monetary policy; market forces alone
determine the money supply. (Here the money supply is defined as the public’s holdings ofnotes and coins plus deposits held with the commercial banking system.)” (Hanke, Jonung
and Schuler 1992, p. 19).
In other words, the currency board is a fixed exchange rate arrangement, similar to amembership in a monetary union. Unlike with a fixed exchange rate system, there is no risk ofa devaluation forced upon the country by outside factors, as the international reserves fully
cover all domestic notes and coins in circulation plus commercial banks deposits at the central
bank (i.e. the monetary base). The board only issues domestic currency to the extent that it hasforeign reserves as backing. Table 5 highlights the differences between a typical currencyboard and a typical central bank.
As a rule, small countries have adopted currency board arrangements. 54 In the 1990s, several
countries in Eastern Europe opted for currency boards. For Estonia and Lithuania, a currencyboard arrangement with the euro as the reserve currency served as stepping-stones into full
membership of the euro area. Outside Europe, Hong Kong is a current example of a “country”
with a currency board. 55
Turning to the case of Iceland, the euro would be the prime candidate to serve as the reserve
asset of an Icelandic currency board. The EU is the main trading partner of Iceland and theeuro is the main foreign reserve currency for Iceland. Euroisation has already taken place at aconsiderable scale, as discussed in the previous section (Section 8.2). In our view, a currencyboard would be a continuation of this process. 56
A currency board for Iceland based on the euro would have a number of advantages. They are
identical to the benefits of membership in a monetary union as outlined in Section 8.2. First, it
54

Imam (2010).
Sometimes the experience of the convertibility plan of Argentina 1991-2002 is viewed as acase of a failed currency board. However, the convertibility plan did not follow the rules of acurrency board. See e.g. Hanke (2008) and Spiegel (2002).
56
A currency board for Iceland could serve as both a temporary and a permanent solution.
The Estonian currency board paved the way for the adoption of the euro as the currency ofEstonia. In case Iceland remains outside the EU, the Icelandic currency board would serve
Iceland well as a permanent arrangement.
55

37

would immediately establish exchange rate stability between the Icelandic currency and theeuro. Consequently, the risk premium imposed on Icelandic interest rates due to exchange rate
uncertainty would be close to zero. Inflation and interest rates in Iceland would rapidly
converge to euro area inflation and euro area interest rates. Eliminating the exchange rate risk
would encourage foreign investment in Iceland, including direct investment, which tend to beless volatile than portfolio investment.
A currency board would protect the Icelandic currency from political pressure andmanipulation better than the present inflation-targeting regime although the present regime
has been isolated from political pressure. 57 Unfortunately, monetary policy in Iceland has along record of political entanglement, which still reduces the credibility of the Central Bankof Iceland. 58 The administration of the currency board would absorb fewer management
resources than central banking does at present because a currency board is much simpler tooperate effectively. A currency board does not need any proper preconditions to work once it
has been set up with sufficient volume of reserve assets. Moreover, a currency board would
most likely start with a stronger reputation than the present CBI.
A psychological advantage with a currency board is that Iceland would be able to retain thepresent currency unit, the króna, denominated in the Icelandic language. This may appeal tonationalistic sentiments. There would still be a national currency as perceived by the public
although it would have a fixed value versus the euro.
Converting the CBI into a full-fledged currency board would be easy. The principal steps forsuch a transformation are described in Hanke, Jonung and Schuler (1992, appendix IV) andsummarized in Table 6. An important issue during this transformation concerns the proper
size of euro reserves of the commercial banking system. In order to withstand any speculative
attack on the commercial banking system, commercial bank deposits must be backed withsafe euro denominated assets. A thorough analysis of the appropriate reserve-to-deposit ratio
is required.
There is one major drawback with a currency board: Iceland would give up what limitedmonetary autonomy it has. In normal times, as argued above, this might not come with any
major drawbacks. It may actually be a gain considering the past performance of the monetary
policy of Iceland. However, it might be a problem if Iceland were to face a deep economiccrisis or shock in the future. With a traditional currency board, there is no authority to act as alender of last resort.
How should this disadvantage be addressed in the case of Iceland? In the traditional case, therole of the central bank as a lender of last resort is to support temporarily ailing banks during
a liquidity crisis. In the severe scenario of a solvency crisis, the resources of a central bank are57

A radical solution to minimize political influence on the currency board would be to place
its main office outside Iceland, for example in Frankfurt, close to the ECB.
58
See chapter 7 in Gylfason et al. (2010), Gylfason (2016) and Sibert (2011).
38

commonly too limited. In this case, the government, that is, the taxpayers, has to step in – if,unlike the case during the crisis in Iceland in 2008, the banking system is not too big to be
saved. This would also be a solution under a currency board. In other words, the resolution ofa crisis can be managed by other government agencies than the currency board.
Under a currency board arrangement, the negative effects of a financial crisis can be
minimized. One way is to impose strict capital requirements on the commercial banking
system to limit the probability of a future banking crisis. A second method is to establish astability fund in normal times that can step in and lend to ailing commercial banks during acrisis. Of course, there is always the option of allowing a failing bank to fail. Such a policy
would reduce the moral hazard involved in any scheme where the government feel obliged tostep in to give support.
As monetary history shows, unexpected shocks of great magnitude do occur. Having anescape clause is key to being able to adapt the regime to such shocks. Facing an extreme
event, Iceland could always give up the currency board and the fixed exchange rate implied
and return to a floating exchange rate in which the currency board would be transformed intoa traditional central bank. Compared to a monetary union, a major advantage of the currencyboard is that it offers such an escape from the fixed exchange rate in case of an extreme event.
It would then be possible to return to a currency board after a temporary “time-out”, althoughwith some loss of credibility.
The cost of giving up the currency board should be high, which will ensure that the escapeclause would only be used under exceptional circumstances. Strong safeguards should prevent
politicians in power from abandoning the currency board at their discretionary will. For
example, the constitution of the currency board should state that a supermajority (say, twothirds) of the Icelandic parliament would be required to abolish the currency board and turn it
into a central bank.

9. Which monetary regime is best for Iceland?
Which is the best monetary policy regime for Iceland at this stage? Table 7 summarizes thepros and cons of the various monetary policy regimes discussed above. No regime solves all
monetary problems. Each regime has implications for the conduct fiscal policy, the design offinancial supervision and the degree of flexibility required in terms of prices and wages.
One approach to find the best regime is through the guidance of monetary history. Ourinterpretation of the historical record points to five policy lessons: i) rules-based regimes
where the monetary authority sticks to the rules last longer that policies based on
discretionary policy decisions; ii) no regime has a permanent life – as the economy changes,
so does the best choice of regime; iii) escape clauses from the rules are necessary when therules become destabilizing rather than stabilizing; iv) small countries have great difficulty39pursuing internationally independent monetary policies; and v) real economic and financial
stability does not automatically follow from inflation (price) stability.
Based on these lessons we rule out a flexible exchange rate and an inflation target for Iceland.
A fixed exchange rate regime is our preferred choice. A pegged exchange rate regime such as
Denmark’s requires a high degree of trust in monetary policy and it is sensitive tointernational speculative attacks. A monetary union provides stability but does not offer any
escape clause.
Consequently, we suggest that Iceland set up a currency board with the euro as the reserve
currency. The króna would persist as the currency unit of Iceland, with the euro circulating as
a parallel currency. A currency board would remove the devaluation (exchange rate) risk
while giving similar benefits as a monetary union. In addition, a currency board would permit
an escape clause if Iceland would be struck by an exceptionally large economic crisis. Using
the escape clause should be costly to prevent the Icelandic government from breaking therules of the currency board under normal circumstances.
A currency board would provide transparent and strict policy rules that make monetary policy
predictable and credible. The international value of the króna would be fixed, which would
enhance foreign trade. On the negative side, a currency board only delivers monetary stability.
It is not sufficient for macroeconomic or financial stability. Without a flexible exchange rate
as a buffer against external shocks, domestic prices and wages must be flexible to adjust tochanges in competitiveness. The sole task of a currency board would be to exchange króna foreuros. It would have no ability to finance government deficits or act as the lender of last resort
during a banking crisis.
The introduction of a currency board should be accompanied by a wide-ranging reform
package to foster fiscal stability, wage and price flexibility, and financial stability. These
reforms should be undertaken preferably before or at least at the same time as the currencyboard is established. We suggest that Iceland consider a system of independent buffer funds tohelp stabilize the economy due to variations in international demand for its exports. Suchfunds will help to stabilize the economy and reduce the need for wages and prices to adjust.
All monetary policy regimes require the support of both the government and the generalpublic. The first step to establish a currency board would be an open and frank dialogue with
the Icelandic population about the pros and cons of the board. The aim of the debate would be
to inform the public of the reasons to shift to a currency board. Such an open debate isnecessary to build trust in the future monetary policy of Iceland.

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47

Table 1. Monetary policy regimes in Sweden 1834-2017
RegimeSilverGold
PaperGold bullion (de facto)
Price level targeting
Fixed vs British pound
Fixed vs US dollar
Member of Bretton Woods
Member of Currency snake
Fixed vs currency basket
Fixed vs ECU
Inflation target announced
Inflation target came into effectIntroduced Lasted (years)
1834
39
1873
41
1914
7
1922
9
1931
2
1933
6
1939
12
1951
22
1973
4
1977
14
1991
1
1993
--199522 (so far)Source: Jonung (2000). https://www.nationalekonomi.se/filer/pdf/28-1-lj.pdf

48

Table 2. Macroeconomic performance under three monetary regimes in Sweden.

Monetary

FiscalTrust inpolicyInflation target

1953-1972

Full Employment 19731992

CPI-inflation

3.8

8.3

1.1

(%)

(2.0)

(2.8)

(1.2)

---

---

GDP-deflator

4.0

8.4

1.7

(%)

(2.0)

(2.7)

(0.8)

Budget balance

-1.2

-5.3

-0.1

(% of GDP)

(1.0)

(3.9)

(2.8)

Expected inflation,
households

---

6.3

1.9

(1.7)

(0.6)

1.75

1.46

2.80

Performance

Bretton-Woods

MeasureCPIF-inflation(%)(%)
Wage contracts(length years)

Realeconomy1.5(0.7)

Economic growth (GDP,
%)

4.1

1.5

2.6

(1.3)

(1.7)

(2.3)

Livnig standard

3.3

1.5

2.0

GDP/capita, %)

(1.6)

(1.7)

(2.4)

Productivity

4.4

1.5

1.8

(GDP/h, %)

(1.5)

(1.4)

(1.7)

Unemployment

2.0

3.1

7.8

(%)

(0.7)

(1.1)

(1.4)

Nominal RealNominalReal

NominalReal

Credit to private sector

9.5

4.6

12.2

3.8

6.6

5.5

(%)

(2.8)

(4.4)

(4.2)

(5.5)

(4.7)

(5.5)

---

---

10.2

2.9

7.0

5.9

(5.5)

(8.0)

(2.9)

(3.8)

House prices

5.2

-2.1

8.2

0.4

6.4

5.3

(%)

(2.7)

(3.6)

(7.7)

(8.4)

(3.9)

(4.2)

Share price index

8.4

4.6

15.8

7.4

10.4

9.3

(%)

(17.0)(19.2)(26.0)(26.9)(21.7)(21.8)

Credit to households
Financialsector

1995-2016(%)

Note: a. The “best” outcome is highlighted in grey. b. data on credit to households is only available from 1981 and onwards. c.
wage contracts only for period 1952-2005. Updated version based on Jonung (2015).

49

Table 3. Reaction functions of the Swedish, Icelandic and German central banks, 1995-2017.

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷∆𝑖𝑖𝑡𝑡−1∆𝑖𝑖𝑡𝑡𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺∆𝑖𝑖𝑡𝑡𝑈𝑈𝑈𝑈𝑈𝑈𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷∆𝜋𝜋𝑡𝑡−1

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺∆𝜋𝜋𝑡𝑡−1𝑈𝑈𝑈𝑈𝑈𝑈∆𝜋𝜋𝑡𝑡−1

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷∆𝑢𝑢𝑡𝑡−1

𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺∆𝑢𝑢𝑡𝑡−1𝑈𝑈𝑈𝑈𝑈𝑈∆𝑢𝑢𝑡𝑡−1

𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑∆𝑒𝑒𝑡𝑡−1

Constant

SwedenIcelandGermany (ECB)
1995Q1- 2001Q1- 2011Q1- 2001Q1- 2011Q1- 2001Q1- 2011Q12017Q2 2007Q2 2017Q2 2007Q2 2017Q2 2007Q2 2017Q2
(1)
(2)
(3)
(4)
(5)
(6)
(7)
.38
-.19
.22
.30
.14
.23
-.30
(.07)
(.04)
(.22)
(.21)
(.16)
(.23)
(.29)
.32**
.30
.93**
-.64
.61
(.13)
(.35)
(.36)
(.81)
(.67)
.12*
.12
.19
.68**
-.93
.21**
.09
(.06)
(.10)
(.41)
(.24)
(.75)
(0.08)(.25).19***
.07
-.09
.12
.19*
(.06)
(.11)
(.11)
(.14)
(.09)
.04
-.03
-.04
-.28
.15
.05
-.12
(.08)
(.15)
(.14)
(.35)
(.25)
(.14)
(.12)
-.13
-.04
-.04
.38*
-.31
-.03
.13
(.14)
(.10)
(.08)
(.21)
(.24)
(.08)
(.08)
.08
-.12
-.16
-.01
.03
(.10)
(.27)
(.25)
(.21)
(.11)
-.31**-.71**
-.32
-.64
-1.27
-.48**-.78**
(.14)
(.28)
(.51)
(.62)
(.90)
(.20)
(.31)
.30
.50
.27
-.35
-.53
-.20
.19
(.28)
(.45)
(.23)
(.60)
(.44)
(.26)
(.19)
.00
.02
.00
-.05***
.02
.00
.00
(.01)
(.02)
(.01)
(.02)
(.02)
(.03)
(.01)
.01
0.00
-.02
.09
-.12
.00
-.11**
(.02)
(.02)
(.08)
(.10)
(.14)
(.10)
(.04)

Adjusted
.81
.53
.33
.66
.26
.66
.24
R2
*, **, and *** denotes statistical significance at the 10%, 5% and 1% level respectively.
Note: parameters that are statistically significant at the 5% significance level are highlighted
in grey.

50

Table 4. Alternative exchange-rate arrangements. A stylized view.
A. Fixed exchange rates
A1. Truly fixed rates: a monetary union with a common currency (euro area)
A2. Fixed, adjustment possible but difficult: currency board (e.g., Hong Kong)
A3. Fixed, adjustment possible but difficult: commodity money (e.g., gold, silver)
A4. Fixed but adjustable: fixed exchange rate vs other currency or basket or currencies (e.g.,
Bretton Woods, ERM)
B. Floating exchange rates
B1. Rules-based systems: inflation targeting (Sweden, UK, euro area), monetary targeting(Bundesbank pre-1999)
B2. Rules-based systems: multiple goals (inflation, employment) (United States)
B3. Discretionary systems: no fixed rules
Source: Updated version of Table 1 in Bordo and Jonung (1997, p 290). The table ignores theuse of capital controls that enhance domestic monetary independence regardless of the regime
adopted.

51

Table 5. A typical currency board versus a typical central bank.
Typical currency board
Typical central bank
Fixed exchange rate to the reserve currency
Floating or fixed exchange rate
Supplies only notes and coins in domestic Supplies notes, coins and deposits incurrency
domestic currency
Foreign reserves of minimum 100 per cent
Variable foreign reserves
No independent monetary policy
Independent monetary policy
Not a lender of last resort
Lender of last resort
Not a regulator of commercial banks
Sometimes regulator of commercial banks
Protected from political pressure
Often politicized
Cannot finance spending by domestic Can finance spending by domestic
government
government
Small staff
Large staff
Rapid monetary reform
Slow to reform
Note: The characteristics listed above are those of an “average” currency board or central
bank, not of a theoretically ideal currency board or central bank.
Source: Revised version of Table 1.1 in Hanke, Jonung and Schuler (1993, p 6).

52

Table 6. How to convert a central bank into a currency board: a stylized approach.
1. Delegate to other bodies all central banking functions that do not directly concern
influencing the supply of money
2. Abolish the central bank’s power to create credit
3. Separate the central bank’s commercial banking functions (if any) from its currency
issuing functions
4. Make sure that the existing reserves of commercial banks are sufficient5. Convert all remaining commercial bank reserves with the central bank into currencyboard notes and coins or into foreign assets, as the commercial banks prefer.
6. Fix an exchange rate
7. Ensure that foreign currency reserves are equal to 100 per cent of the note and coincirculation
8. Transfer the remaining assets and liabilities of the central bank to the new currency board
and open the board for businessNote: This list is taken from Hanke, Jonung and Schuler (1992, appendix IV).

53

Table 7. Pros and cons of various monetary policy regimes. A stylized view.
Regimei)ii)
iii)

Inflation targeting

i)

ii)
iii)
iv)

i)
ii)
iii)
Fixed exchange rate
i)
ii)
iii)
i)
ii)

Currency board

iii)
iv)

i)
ii)

i)
ii)
iii)
iv)
Monetary union

i)
ii)
iii)

Pros and cons
Pros
Monetary independence implying that the policy rate can begeared towards domestic conditions.
The exchange rate may serve as a buffer against big economic
shocks.
In principle, no need for foreign reserves held by the central
bank.
Cons
Monetary independence restricted by global financial linkages
for a very small economy like Iceland. (Capital controls may be
used to increase independence.)
Exchange rate volatility in a very small economy like Iceland
may reduce welfare.
In practice, large foreign reserves may be needed for a small
open economy like Iceland.
Qualified professionals needed for the management of thecentral bank.
Pros
Facilitates trade.
Can achieve price stability by tying the exchange rate to a low
inflation country.
The exchange rate can be changed in Escape clause possible if
something goes wrong (i.e., devaluation).
Cons
Monetary policy dependent on global interest rate.
Requires a credible policy. Risk premium can be high,depressing the domestic economy.
Invites speculative attacks on the fixed rate.
Pros
Facilitates trade.
Can achieve price stability by tying the exchange rate to a low
inflation country.
Instant monetary credibility.
Possible to revert to the national currency in case of extreme
crisis.
Cons
No monetary independence.
Foreign reserves necessary to set up the board (though inpractice this problem has proved easy to address).
Pros
Facilitates trade.
Domestic policy credibility imported through monetaryunification.
No foreign currency reserves needed.
Limited management resources necessary for running amonetary union.
Cons
Monetary policy dependent on global interest rate.
In case of crisis, no escape clause is available through changes
in the national currency.
Difficult to revert to domestic currency during a crisis.

54

13
11

% inflation

9
7
5
3
1
-1

CPI-inflation

CPIF-inflation

Perceived inflation

Tolerance band

2017Q1

2014Q1

2011Q1

2008Q1

2005Q1

2002Q1

1999Q1

1996Q1

1993Q1

1990Q1-3

Figure 1. Inflation in Sweden according to the CPI-index and the CPIF-index from 1990Q1 to
2017Q2.

55

10

8

%

6

4

2

0

Riksbank

Bundesbank/ECB

2017Q1

2015Q1

2013Q1

2011Q1

2009Q1

2007Q1

2005Q1

2003Q1

2001Q1

1999Q1

1997Q1

1995Q1

1993Q1-2

Difference between Riksbank and Bundesbank/ECB

Figure 2. The central bank policy rate in Germany and Sweden, 1993Q1 to 2017Q2.

56

% expectede finflation

8
6
4
2
0

Firms

Households

2016Q1

2014Q1

2012Q1

2010Q1

2008Q1

2006Q1

2004Q1

2002Q1

2000Q1

1998Q1

1996Q1

1994Q1

1992Q1

1990Q1-2

Tolerance band

Figure 3. Expected inflation 12 months ahead for households and firms from 1990Q1 to
2017Q2 in Sweden.

57

200

Riksbank increases rates following
the financial crisis% of disposable

180
160

Financial crisis 1991-93

140

Riksbank sets a negative policy rateand initiates a QE program.

120
100

Inflation target came into effect
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

80

Household debt (% disposable income)Figure 4. Household debt as percent of disposable income in Sweden, 1990-2016.

58

500
450
400

Riksbank increases rates following
the financial crisis

Index 100 = 2000

350
300
250

Financial crisis 1991-93

200
150
100

Riksbank sets a negative policy rateand initiates a QE program.

50

1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

0

Property price index
Tenant occupied appartments price index

Figure 5. Real property price index and real tenant-occupied apartment price index in Sweden,
1990-2016.
Note: Price index for tenant-occupied homes is only available after the year 2000.

59

6
5
4
3
2
1
0

2020-01-01

2019-01-01

2018-01-01

2017-01-01

2016-01-01

2015-01-01

2014-01-01

2013-01-01

2012-01-01

2011-01-01

2010-01-01

2009-01-01

2008-01-01

2007-01-01-1

Riksbank policy rate

Figure 6. The Riksbank repo rate 2007-2017, and the Riksbank’s forecasted repo rates 20102020.
Note: The actual repo rate is the black line. All other lines in color are the forecasted future
rates.

60

20
18
16
14

%

12
10
8
6
4
2

Q1 1995
Q4 1995
Q3 1996
Q2 1997
Q1 1998
Q4 1998
Q3 1999
Q2 2000
Q1 2001
Q4 2001
Q3 2002
Q2 2003
Q1 2004
Q4 2004
Q3 2005
Q2 2006
Q1 2007
Q4 2007
Q3 2008
Q2 2009
Q1 2010
Q4 2010
Q3 2011
Q2 2012
Q1 2013
Q4 2013
Q3 2014
Q2 2015
Q1 2016
Q4 2016
Q3 20170Central Bank of Iceland interest rate

Federal Reserve interest rate

Figure 7. The Central Bank of Iceland policy rate, and the inflation rate of Iceland and theFederal Reserve interest rate, 1995-2017.

61

Q3 2017

Q4 2016

Q1 2016

Q2 2015

Q3 2014

Q4 2013

Q1 2013

Q2 2012

Q3 2011

Q4 2010

Q1 2010

Q2 2009

Q3 2008

Q4 2007

Q1 2007

Q2 2006

Q3 2005

Q4 2004

Q1 2004

Q2 2003

Q3 2002

Q4 2001

Q1 2001

%
20

18

16

14

12

10

8

6

4

2

0

Figure 8. The inflation rate of Iceland, 2001Q1 to 2017Q4. Gray area illustrates the periodwith capital controls.

62

SwedenDenmark
Norway2016-12-01

2015-10-01

2014-08-01

2013-06-01

2012-04-01

2011-02-01

2009-12-01

2008-10-01

2007-08-01

2006-06-01

2005-04-01

2004-02-01

2002-12-01

2001-10-01

2000-08-01

1999-06-01

1998-04-01

1997-02-01

1995-12-01

1994-10-01

1993-08-01

1992-06-01

1991-04-01

1990-02-01

1988-12-01

1987-10-01

1986-08-01

1985-06-01

1984-04-01

1983-02-01

Index 100 = 2000Q1
175

165

155

145

135

125

115

105

95

85

75

FinlandFigure 9. Real exchange rate index (2000Q1=100) for Denmark, Finland, Norway andSweden, 1983-2017.

63

Real exchange rate index
ISK / USD (index)

2017-08-01

2016-09-01

2015-10-01

2014-11-01

2013-12-01

2013-01-01

2012-02-01

2011-03-01

2010-04-01

2009-05-01

2008-06-01

2007-07-01

2006-08-01

2005-09-01

2004-10-01

2003-11-01

2002-12-01

2002-01-01

2001-02-01

2000-03-01

1999-04-01

1998-05-01

1997-06-01

1996-07-01

1995-08-01

1994-09-01

1993-10-01

1992-11-01

1991-12-01

1991-01-01

1990-02-01

Index 100 = 2000Q1
160

140

120

100

80

60

40

20

ISK / EUR (index)

Figure 10. Real and nominal exchange rate indices for Iceland, 1990-2017.

64