Second, the longer we keep inflation expectations at target, maintain a current account surplus, and continue to pay down debt, the more the risk premium component of interest rates and the equilibrium real rate in Iceland will continue to fall. The current propensity to save, adjusted for the business cycle position, is much greater than it has been for quite a while, and over time, it will contribute to a reduction in the long-term equilibrium real rate. If inflation expectations remain at target, both nominal and real rates will decline accordingly. Exchange rate of the króna and Central Bank foreign currency purchases Responding to the recent strong inflows into the foreign exchange market is one of the Central Bank’s most complex tasks at present. The problem lies, among other things, in distinguishing between short-term inflows, which are only loosely connected to economic fundamentals and are much more likely to stop suddenly or even reverse, and inflows that reflect more lasting positive changes in fundamentals, although these can change for the worse as well. It can be argued that, other things being equal, there should be more foreign exchange market intervention in the former instance and less in the latter. While the foreign exchange reserves were being increased to the desired size during the prelude to general capital account liberalisation, this distinction was less important for policy responses than it is now, as the premises were in place to buy the inflows and top up the reserves, more or less irrespective of the origins of the inflows.

The way forward: moving towards an integrated financial market union As I mentioned already, while monetary policy can alleviate deleveraging pressures in crisis times, it cannot address their root causes. In fact, to tackle the underlying problems, a wide-ranging policy response is necessary, inter alia, pertaining to public finances, economic competitiveness and the financial sector. Given the focus of today’s conference, I would like to use the remainder of my speech to consider the last aspect, namely the institutional framework that governs financial markets in European Monetary Union (EMU). In particular, I would like to address two questions: first, what principles should the institutional architecture be based on in order to be effective in avoiding excessive risk-taking and cross-border fragmentation of banking sectors; and second, how do the on-going reform efforts towards a “financial market union” at European level contribute to these aims? In answering the first question, policy-makers should be guided by two criteria: first, economic actors that stand to gain from risky activity should also bear the associated downside risk. To be concrete, a system, in which banks can expect to be bailed out by taxpayers if their investment decisions go wrong, is neither efficient not fair. Second, the  BIS central bankers’ speeches  5  institutional architecture of EMU should achieve a level of integration that is commensurate to the integration of its banking financial sectors. Hence, there should be no systematic cross-country differences in the design and implementation of the rules that govern financial markets.