. in other respects, the answer is determined by the structure and cyclical behaviour of the economy in question, the maturity of its markets, and whether cross - border movement of capital is largely unrestricted or not. the more open an economy is, the stronger the arguments for an exchange rate target because inflation is determined to a greater degree by the exchange rate. on the other hand, the less correlated shocks and cycles are with those in trading partner countries, the stronger the arguments for an inflation target and a floating exchange rate. therefore, the two characteristics of small economies that i mentioned earlier bis central bankers ’ speeches pull in opposite directions. this does not change the fact that, other things being equal, smaller economies are likelier than larger ones to have an exchange rate target. underdeveloped financial markets can be obstacles to the pursuit of an inflation target and a floating exchange rate. an example of this is the conditions in iceland before the 1990s, when we lacked a money market for kronur and an interbank foreign exchange market. less restricted movement of capital pulls in the other direction, however, as it can be more difficult to achieve an exchange rate target, and the negative implications for financial stability, when central banks are forced off the target, have often proven more pronounced. as a result, it is no coincidence that countries around the world shifted from exchange rate targeting to inflation targeting as capital movements were liberalised in the late 1980s and the 1990s. the answer to the question of inflation target versus exchange rate target therefore differs from country to country and from time to time, as our own history shows so clearly. from the time the central bank of iceland was established in the early 1960s until the beginning of the 1990s, the bank pursued an exchange rate target, with fixed - exchange rate episodes of varying lengths interrupted by periodic devaluations, apart from one revaluation in 1973. the markets were underdeveloped, and reserve requirements and lending restrictions were the main policy instruments, but they were relatively toothless because of the treasury ’ s unrestricted borrowing from the central bank and, for a time, the partial relending of reserve requirements as inventory credit to exporters. at the beginning of the 1990s, the interbank markets for money and foreign exchange were developed, which created the conditions for the conduct of monetary policy as we now know it, with the bank ’ s interest rates for transactions with deposittaking institutions as the main policy instrument. restrictions on movement of capital were lifted

##rona not slipping much from its level over the past few months, at least for as long as pronounced macroeconomic imbalances remain. confidence in the exchange rate will be a crucial factor over the coming months. it should also be pointed out that exchange rate movements can be the result of external events or changes beyond our control, such as a sudden shift in international investors ’ risk perceptions or global credit supply. the exchange rate of the krona is closely linked to developments in capital markets elsewhere in the world, especially while the current account deficit is as large as at present. inflation and macroeconomic forecasting the central bank bases its monetary policy formulation and implementation on the inflation and macroeconomic forecast that it prepares three times a year and publishes in monetary bulletin. forecasts are always uncertain and by definition can never state precisely what will happen over the forecast horizon. the central bank forecasts are based on extensive research and analysis, and on models that have been developed to simulate how events are likely to unfold. a major advance was made in 2006 with the introduction of a new macroeconomic model designed by central bank economists. the central bank has always expressed qualifications about the accuracy of its forecasts, and readers of monetary bulletin will be familiar with the risk profiles that draw attention to forecasting uncertainties. another uncertainty is the output gap at any time, which is an important determinant of the inflation outlook. however, the economic laws are known and are the same as everywhere. forecasts are prepared on the basis of the best available information and known correlations between changes in aggregates. they therefore provide a sufficiently good indication about future developments to enable the board of governors to make decisions on the basis of them. better forecasts have not been available. nonetheless, the central bank has frequently been criticised for the quality of its forecasting and the allegedly incorrect monetary policy decisions based on them. for example, the bank came under harsh fire for raising the policy rate in the second half of 2006. it was claimed that the forecasts were wrong and the hikes therefore unnecessary. in some cases, critics selected limited and minor areas of central bank forecasts which they considered to be based on incorrect assumptions, and dismissed the entire forecast as a result. now that the year is over, it is obvious, of course, that the bank ’ s forecasts did not fully hold. for instance, in july 2006 the bank forecast higher second - half inflation than proved to be the case. explanations for the deviation include the