prime minister ’ s approval. this provision incorporates into law the policy introduced on march 27 this year when the monetary framework was changed and the flexible fixed exchange rate was replaced with an inflation target and floating exchange rate. despite very detailed discussion of the framework changes and the fundamental principles of the new policy, the bank has often noticed widespread misunderstandings. i shall therefore outline the broad principles of monetary policy. inflation is a monetary phenomenon the central bank was assigned a specific inflation target in the joint declaration which it issued, with the government, on march 27. this stipulated that the bank should aim for a rate of inflation as close as possible to 2½ %. tolerance limits were also set, 1½ % higher than the inflation target and 1½ % lower. the inflation target was defined as the twelve - month rise in the cpi. if inflation exceeded the tolerance limits, the bank would be obliged to bring it back within them as quickly as possible. at the same time the bank would be obliged to submit a report to the government, which would be made public, stating the reason for the deviation, its planned response and the length of time that it expected to take to bring inflation back within target. when the target was set, inflation was running relatively high in iceland. bearing that in mind, the upper tolerance limit was set for 6 % this year, 4½ % in 2002 and then 4 % from the year 2003 onwards. upheavals in the foreign exchange market in the spring and a sharp depreciation of the krona caused a substantial rise in inflation, which exceeded the upper tolerance limit in june. the central bank submitted a detailed report to the government on june 20. other aspects of the joint declaration included a provision that, notwithstanding the abolition of the exchange rate target band, the central bank would intervene in the interbank market in foreign exchange by buying and selling currency if it deemed this necessary in order to contribute towards attaining the inflation target, or if it viewed exchange rate swings as a threat to financial stability. at the same time, the central bank undertook to produce a quarterly inflation forecast projecting two years into the future. it should be remembered that one of the main reasons for the simplification of central bank targets in recent years, and for assigning them the main objective of price stability, is that inflation is primarily a monetary phenomenon and the long - term impact of monetary policy is above all on prices. its impact on economic growth and employment is therefore generally only temporary. since central banks

##ate from the euro by more than 2. 25 % from a defined central rate. denmark therefore enjoys limited monetary independence. this is reflected in the fact that the danish central bank invariably alters its interest rates in the wake of announcements of changes in the european central bank ( ecb ) policy rate. sweden and the uk have opted for inflation targeting as their monetary policy framework, which therefore does not have the objective of keeping these countries ’ currencies stable against the euro. european central bank the maastricht treaty stipulates monetary arrangements in the emu. the eu countries created a framework for the ecb ’ s activities which was to some extent modelled on the central bank of germany but differed in many ways from the arrangements in others. various conditions were set which eu members had to fulfil in order to be granted emu membership. on the one hand these related to major components of economic developments, such as inflation, fiscal deficit, government debt and interest rates. on the other hand they addressed the framework that the maastricht treaty lays down for monetary policy implementation in the emu. this policy was consistent with growing support for the view that it was natural to set a simple target for central banks – i. e. promoting price stability – and to increase their independence from the political leadership in pursuing their main objectives, and to strengthen their financial independence. another emphasis was that, at the same time as the central banks ’ independence was strengthened, stricter demands would need to be made of them regarding transparency in their activities and actions, and regarding accountability towards the government and general public. all this was reflected in the maastricht treaty. the european central bank, which formally began operation in the middle of 1998, enjoys extensive independence and is subject to requirements for transparency and accountability. even though sweden is not yet a member of the emu, it amended legislation on its own central bank which now largely fulfils the maastricht terms. the bank of england ’ s legislation does not entirely fulfil the terms of the treaty, but it was granted greatly increased independence a few years ago. denmark has still not amended its central bank legislation, although this will need to be done in the event of denmark joining the emu, not least to give legal sanction to its independence. price stability is the main objective the maastricht treaty set a single objective for the european central bank, namely ensuring price stability. price stability was not defined in the treaty