Seminar: Fridrik M. Baldursson, School of Business, Reykjavik University

Titel:

The krona and the crisis: the role of currency and monetary policy in the Icelandic banking collapse.

Abstract: Iceland adopted an inflation targeting regime in March 2001: the Central Bank of Iceland (CBI) was given the mandate to keep inflation close to 2.5% per annum with its policy rate as the main instrument. The inflation targeting regime – as implemented and as it interacted with other economic policies and private sector developments – served Iceland badly. This paper describes how the IT regime amplified the boom-bust cycle in Iceland. Monetary policy, with the world’s smallest freely floating currency, the Icelandic krona, as vehicle, was an important factor in behind the financial crisis that culminated in a near-total collapse of the Icelandic banking sector in October 2008. The krona also played a major role in the actual mechanics of the collapse. Serious policy mistakes were made: the Government of Iceland ran a procyclical fiscal policy and undermined monetary policy through the government’s Housing Financing Fund; the Central Bank made a crucial mistake and undermined its own policy on inflation and financial stability by adopting an unofficial exchange rate target. While the Bank raised interest rates in an attempt to curb inflation it indicated that the krona would not be allowed to depreciate too much; exchange rate paths seen as compatible with the bank’s inflation predictions were published. Large inflows into the krona (carry trade) and pervasive foreign currency borrowing by Icelandic firms and households followed.