. the principal objective as stated in the declaration, is to keep inflation as close as possible to 2½ per cent. should inflation deviate from this target by more than 1½ percentage points in either direction, the bank is to provide the government with a written public account explaining what caused this deviation, how the bank intends to respond and how long it expects that it will take for inflation to return to within the targeted inflation limits. in the wake of this declaration, the icelandic parliament adopted a new legislation on the central bank, giving it one overriding goal, i. e. price stability, and full independence to use its instruments to achieve it. the new framework was immediately subjected to a baptism of fire. overheating in the economy and the fall of the krona had rekindled inflation. as can be seen from chart 2, inflation climbed rapidly from below 2 per cent in 1997 and 1998 to a peak of 9. 4 per cent in january 2002. at the same time the short and medium term growth prospects of the economy deteriorated. facing conflicting demands, from the inflationary pressures stemming from a weakening currency on one hand and the outlook for a slowing economy on the other hand, the central bank opted to lower interest rates by ½ percentage point when the new monetary framework was announced. but that cut was made from a very high level as the policy rate had peaked at 11. 4 per cent. the central bank kept a tight monetary stance until the spring of 2002, when it was clear that inflation would decline. within less than one year, inflation was reduced from nearly 10 per cent to the target of 2½ per cent, and even below it for a while. furthermore, the current account deficit disappeared in a matter of two years, partly due to the depreciation of the krona. this turnaround was much more rapid than might have been expected and is almost unparalleled among the developed countries. the economy is currently in a relatively good balance. but once you are in calm waters new challenges usually emerge. ahead are new investments in the aluminium sector and related power plants, that will commence in 2003 and most likely continue until 2010. in economic terms these new investments will amount to over 30 per cent of one year ’ s gdp and increase iceland ’ s annual production capacity of aluminium from 270 to 740 thousand tons. the economy appears to have already begun adapting to the coming projects as reflected in exchange rate movements. as can be seen in chart 2. the krona was

direction to 6 per cent in september 1995 in order to allow for the possibility of greater fluctuations in the exchange rate with more volatile capital movements. in february 2000 the target band was widened further to 9 per cent in either direction in order to create greater scope for monetary policy which was increasingly focusing on the maintenance of price stability. recent experience around the world has demonstrated that it is difficult to maintain soft exchange rate pegs with free capital movements, and the same has been the case in iceland. furthermore, developments in the domestic economy at the end of last decade were such that the stable exchange rate policy was gradually undermined. during the second half of the 1990´s, the icelandic economy entered a period of high economic growth. growth was initially well balanced and led by exports and increased investment in the private sector. but as it unfolded it became increasingly driven by consumption and investment in the non - traded goods sector, fuelled by a foreign financed credit expansion in the wake of intensified competition among lending institutions and a significant increase in credit availability. by 1998, signs of overheating were already increasingly visible in rising inflation and the ballooning current account deficit which climaxed in 2000 at 10 per cent of gdp. the central bank responded to the imbalances in the economy by tightening monetary policy. through the effects of the tighter monetary policy, the exchange rate of the krona gradually appreciated as can be seen from chart 1. in the spring of the year 2000 expectations in the market shifted for a variety of reasons ; but concerns about the current account deficit and lower expectations of future economic growth were the most important. subsequently the krona began to depreciate and continued to do so more or less uninterrupted, but on the whole in an orderly fashion, over a period of a year and a half until the end of november 2001. by that time, it had fallen from its peak by about a third against other currencies. as i mentioned before, experience has shown, that in the long run, it is very difficult to maintain soft exchange rate pegs with the free movement of capital across borders. iceland shares this experience with many other countries during the post - liberalisation face. the response to this has been the observed tendency to adopt hard pegs in the form of monetary unions or currency boards or to go in the direction of floating. as so many other countries, iceland adopted the second route. this was done in march 2001 by a joint declaration by the government and the central bank