mar guðmundsson : financial integration and central bank policies in small, open economies – what are the key lessons from the crisis? remarks by mr mar guðmundsson, governor of the central bank of iceland, in a plenary session on monetary policy and policies of central banks at the singapore economic review conference, singapore, 5 august 2015. * * * a revised and extended version of this talk will be published in a forthcoming singapore economic review. chairman and participants, i would like to thank the organisers for inviting me to speak at your conference here in singapore, a country that i have long respected for its economic management. my remarks today bear the title financial integration and central bank policies in small, open economies : what are the key lessons from the crisis? they are motivated by my experience as a policy - maker from a very small, open, and what used to be financially integrated economy, and my tenure at the bank for international settlements. 1 there is a widespread sense that global financial integration can be problematic for the conduct of monetary policy in small, open economies. why is that? it is well known that the transmission mechanism of domestic monetary policy evolves as domestic financial markets develop, and that this in turn affects the relative effectiveness of different monetary instruments. the same applies to external liberalisation of domestic financial systems and the cross - border financial integration it gives rise to. initially, it can give a boost to domestic financial market development. but as it progresses and we at the global level get closer to the limiting case of free and frictionless capital movements, then real risk adjusted asset returns increasingly become equalised across countries. as that happens, less and less of the transmission of monetary policy goes through what i call the interest rate channel. there would still be an interest rate channel at the global level, but that would be determined by the big countries. the small, open economies that have adopted a floating exchange rate could still achieve their inflation targets through the exchange rate channel. the scope for short run output stabilisation would be more limited, however. is this necessarily a problem? if the exchange rate channel were relatively well behaved – i. e., if it provided smooth adjustment based on fundamentals and uncovered interest rate parity broadly held over relevant horizons – then the answer might be no. the problem is, however, that experience has shown that uncovered interest parity does not hold except perhaps over long horizons. interest rate differentials give rise to widespread carry trading, which is by

so on. although it is perhaps most natural to think of this mothballing behaviour in the context of manufacturing, it was also apparent within the services sector. it was relatively commonplace for professional services companies to encourage staff to take sabbaticals at much reduced pay. aircraft were taken out of service. shops were left empty. this type of adjustment has helped uk industry to withstand the effect of the recession. it reduces companies ’ average costs and so protects their profitability during the period of weak demand. a by - product of this adjustment, however, is that the marginal cost of producing additional output is higher. although the mothballed capacity can be reinstated, it is likely to be more costly to do so, especially in the short - run, than if the resources were simply standing idle. assembly lines need to be serviced before being restarted ; staff need to be brought back from sabbaticals. as a result, the downward pressure on costs and prices stemming from the latent spare capacity within companies, at least in the near term, is likely to be less. 6 developments in margins consider next the mark - up over and above costs that companies include in their selling price. in the past, margins in the uk have tended to fall back during periods of weak demand and vice versa. 7 one possible reason for this is if companies reduce their prices relative to their costs when demand is weak in order to gain market share which they hope to hold onto as demand increases, ie they hope to be able to exploit some degree of pricing power. if successful, the lower profits in the downturn are outweighed by the gains during the upswing. this pro - cyclicality of margins is another reason why inflation in the uk has tended to moderate during periods of weak demand. but margins appear to have fallen by less during the recent recession than expected given the marked contraction in demand. simple measures of margins, such as the profit share, have been relatively resilient. and a recent survey by the bank ’ s agents suggested that margins on average were only a little below normal, despite the marked contraction in demand. 8 why so? in part, aggregate margins may have been boosted by the sharp rise in sterling export prices following the depreciation of sterling. the increase in exporters ’ margins may well have masked a decline in margins earned by domestic producers. that is consistent with some surveys of companies ’ capacity utilisation, which do not seem to have fallen by as much as the