between residents. capital inflows from non - residents are much less important, and in the latter half of the year, when the krona was appreciating the most, carry traderelated inflows were virtually non - existent. estimating the equilibrium real exchange rate is very uncertain, however, and as a precaution, the central bank has leaned against potential overshooting of the exchange rate by buying large amounts of foreign currency. in this light, it is difficult to conclude otherwise than that the appreciation of the krona has been largely benign, in that it is based on economic fundamentals and contributes to a better balanced economy. the central bank ’ s scenario analysis indicates that if the bank had used policy instruments to halt the currency appreciation in recent years, economic imbalances would have been much greater and inflation considerably higher. it has been a long time since the central bank of iceland could fix the exchange rate unilaterally on a day - to - day basis. the exchange rate is determined in the interbank market and reflects underlying supply and demand for foreign currency. but the bank can affect the exchange rate through interest rate decisions, foreign exchange transactions, and the application of capital flow management measures such as the one currently in place : the special reserve requirements on certain types of capital inflows. the exchange rate would have been much higher if the bank had not applied these instruments and bought large amounts of foreign currency. but could the bank have gone further ; for instance, by buying even more foreign currency or by lowering interest rates more than was warranted by economic conditions and the inflation outlook? certainly it could have done so ; it could even have gone as far as to more or less halt the appreciation of the krona. but then large interest rate cuts would probably have been needed alongside the foreign currency purchases, perhaps even bringing real rates into negative territory, which is ill - suited to an economy with a positive output gap and very strong gdp growth. the reason is that in order to lower interest rates enough to materially increase residents ’ appetite for investment in foreign securities, an interest rate cut of 0. 25 or 0. 5 percentage points would not be sufficient because of how wide the interest rate differential currently is. it is not a given, either, that long - term interest rates in the bond market would have followed suit in full, and bond market rates are more important for investments by pension funds and other investors than the central bank ’ s short - term

interest rates have been raised in the us, and the period of very low or even negative interest rates in the euro area may be coming to an end. this has various effects on the icelandic economy. it is not a given that terms of trade will continue to improve, and imported deflation will subside as well. domestic inflation could therefore rise above target more quickly unless domestic pressures ease commensurably. on the other hand, the interest rate differential with abroad will narrow, other things being equal, and this will make the conduct of monetary policy less difficult and reduce the central bank ’ s accounting loss due to the foreign exchange reserves, as i will discuss more fully in a moment. monetary policy conduct is generally much more complicated during times of significant change than under calmer conditions. the signposts of the policy – such as equilibrium interest rates, output, unemployment, and the exchange rate – could begin to move. however, because these variables are not observable but must be derived from developments in other variables, it is highly uncertain at any given time how much they have changed once they start to move. furthermore, relative prices change more than they did before, but monetary policy cannot affect them except in the short term. sometimes it can be difficult to distinguish between such relative price changes and a general rise in the price level, which depends in the long run on monetary policy. in addition to this, it can often be difficult to determine at any given time which changes are temporary and could possibly be mitigated through economic policy and which ones are more permanent and nothing much can be done about, at least through monetary policy. these are exactly the conditions we are experiencing at present. there are clear indications that the equilibrium real exchange rate has risen with improved terms of trade, increased national saving, and a vastly improved external position. in addition, there are indications that equilibrium interest rates have fallen since before the crisis, and they have probably fallen still further as monetary policy has grown more credible and inflation expectations have been anchored more firmly at the target. in both instances, the question of how much remains unanswered. as far as the exchange rate is concerned, conventional measuring methods do not indicate that the real exchange rate is clearly above its equilibrium level. this is supported by the bank ’ s analysis, to be published next week in financial stability, which shows that 85 % of inflows into the foreign exchange market in 2016 were attributable to the current account surplus and transactions