The Monetary and Exchange Rate - Coursework Example

Iceland’s macro-economic position and monetary and fiscal ities The paper describes the issues mostrelevant for the decision on the monetary and exchange rate framework to be adopted in Iceland after the conclusion of the Government-IMF program. It is essential to consider the alternatives available considering the reasons that the monetary policy regime adopted earlier in the decade has not proved sufficiently successful. Although based on best practices as suggested by the economic literature and the experience of many successful countries, inflation performance has been poor for most of the period since the adoption of the inflation-targeting regime. A number of reasons are available for this. For example, the structure of the Icelandic economy makes independent monetary policy more difficult to implement, national and international economic and financial market conditions have been highly unusual, and the formulation of monetary policy, which did not succeed in gaining sufficient credibility, was somewhat imperfect. Moreover, increased globalization of the national financial system and its rapid growth are likely to have weakened the transmission channels of monetary policy and increase the underlying risk in the financial system, which magnified the volatility of the exchange rate. Sufficient co-ordination between monetary and fiscal policy was also lacking, which exacerbated the negative side effects of financial restraint. A fixed exchange rate regime has advantages and disadvantages. The main benefit is the uncertainty accompanying exchange rate fluctuation is reduced, particularly if the peg proves credible and speculative attacks can be avoided. If Iceland were to adopt a fixed exchange rate regime, it would be most obvious from an economic point of view to peg the krona to the euro. Such a regime could be implemented in different ways. Experience from the financial crisis, both in Iceland and elsewhere, indicates a need for further strengthening of monetary policy and macroeconomic policy in general. The experience of recent years highlights the importance of implementing stabilization policy so as to hinder rapid, unsustainable asset price inflation, which is usually accompanied by excessive credit expansion. It is also important to prevent the banking system from creating risks that are beyond the ability of the national authority to deal with it. The paper analyses policy adoption by monetary and fiscal authorities in the recent years as well as the coming years in Iceland. Keywords: financial system, macroeconomic, monetary and fiscal authorizes, inflation, economic policy, Introduction In the past two years, the formulation of monetary policy has reflected the capital controls, and more recently, foreign exchange market intervention, together with a more conventional interest rate tool with the aim of promoting exchange rate stability and declining inflation. This has prepared the ground for the financial restructuring of financial institutions and the corporate and household sectors. The capital controls cannot remain in effect indefinitely, once the IMF programme has run its course, without radical changes in Iceland’s stance on economic and international affairs. In addition to the undesirable microeconomic costs, the capital controls are in contravention of Iceland’s international obligations, including the European Economic Area (EEA) agreement. Thus, when Iceland’s collaboration with the IMF concludes, the country requires a new monetary policy framework. It is inevitable that the new structure will reflect the poor performance of independent monetary policy in Iceland in the past decade, and, in fact, its entire monetary history since the Icelandic krona was separated from the Danish krone. It is, therefore, important to ask how it is possible to ensure similar financial stability as has been achieved in most other countries, both industrial and emerging market. From the request of the Prime Minister, the Central Bank prepared a short report on this issue in June 2009. The report explores the options that are considered most viable in more detail. The paper highlights the issues that are important when considering the appropriate monetary and exchange rates arrangements for future in Iceland, on the basis that it will continue with its own currency. Decisions in these matters must obviously take account of the fact that Iceland is currently engaged in accession negotiations with the European Union (EU). The results of those discussions and the national referendum on the matter will determine Iceland’s long-term monetary regime. That, however, will not have been determined by the time the IMF programme concludes. Consequently, it is necessary to formulate financial policy arrangement that can be followed until the EU question is defined and, if EU membership is rejected in a national referendum, for the longer term. If European Union membership is rejected as well as the membership in the Economic and Monetary Union (EMU), the likely outcome will be a monetary policy with an independent policy. Iceland’s current inflation targeting policy is insufficient on its own. Therefore, monetary policy adoption will need to look beyond inflation (Fragetta & Kirsanova 2010, 860). Monetary policy in Iceland Inflation developments in a historical context The Icelandic krona was at par with the Danish krone until 1920, when they were formally separated. The Danish krone now trades at about 20 Icelandic kronur, but adjusting for the denomination of the Icelandic kronur in 1981, the Danish krone is now worth approximately 2,000 pre- 1981 kronur. The value of the Icelandic kronur versus the Danish krone is, therefore, only 0.05% of its 1920 value or, to put it differently, the Icelandic krona has lost 99.95% of its value to the Danish krone over this 90-year time. The purchasing power of the krona has eroded even more. When considering the overall consumer price index (CPI), the value of each krona in June 1944 was equivalent to 7,147 old kronur (71.47 new kronur) by August 2010. In terms of the CPI excluding the housing component, the 1944 kronur was worth 10,377 old kronur (103.37 new kronur), which means that the value of the currency has fallen by 99.99%. The monetary history of Iceland has therefore, been a rocky path right from the start, irrespective of which financial and exchange rate regime the country has developed. The erosion of the krona has not been a steady process, but periods with low and stable inflation are few and brief. In 1990s, the inflation in Iceland was comparable with other countries (Stiglitz 2001, par 2). During that time, Iceland followed a fixed exchange rate regime, pegging the krona to a trade-weighted exchange rate index. Except for two currency devaluations in 1992 and 1993, the Central Bank was able to hold the krona relatively stable from 1991 to 2000. The exchange rate band was first expanded when exchange rate pressures began to mount, and in March 2001, Iceland abandoned the fixed exchange rate policy, floated the krona and adopted an inflation target as a new nominal anchor. At that time, it widely agreed that, with free international capital movements, it would be extremely difficult to maintain a unilateral fixed exchange rate, especially in such a small currency area (Dixit & Lambertini 2001, 982). Monetary policy based on inflation targeting At March year in Iceland 2001, the Central Bank adopted an inflation target and with an amendment to the Bank’s act in May the same year, price stability was defined as the primary objective of monetary policy, in line with ideas on monetary policy implementation and the experience of other countries. The Government and the Central Bank as a numerical inflation target specified the price stability goal in the joint declaration. According to a joint declaration, the Central Bank was to ensure that year on year inflation remained as close as possible to 2 percent. This arrangement was similar to the monetary policy framework that had become more common around the world after New Zealand adopted an inflation target in early 1990. By the end of 1998, 10 countries had adopted a formal inflation target. In the ensuing five years, that number had roughly doubled. The increase in the past decade has been concentrated mostly among emerging market economies (Woodford & WALSH 2005, 9). The main goal and reason to target inflation is to provide a stronger anchor for inflation expectations. The idea is to try to increase the effectiveness and efficiency of monetary policy is to control inflation and give it more scope to contribute to general well- being, within the framework set by the inflation target. The co-ordination of monetary and fiscal policy The experience of recent years shows also that co-ordination between monetary and fiscal policy sorely lacked in Iceland during the boom years, with these two arms of macroeconomic policy arguably pulling in opposite directions. There was a surplus on Government operations during this time, due mainly to sizeable temporary tax revenues from turnover and income during the upswing. The lesson learnt from the upswing, however, is that the fiscal surplus is not a sufficient measure of fiscal restraint and its contribution to stabilization policy. A better measure is the change in expenditures and taxes, which indicates that fiscal restraint in Iceland was far from adequate during the pre-crisis period. Taxes were cut significantly and expenditures regularly exceeded budgetary targets. The policy mix of Iceland becomes insufficient if viewed in a broader context. It is clear that the major development projects undertaken with the support of the Government in the early part of the decade severely strained the economy’s resources (Scharpf 2011, par 3). They ought to be equal and have acquired much more stable fiscal policy to offset them. The privatization of Iceland’s large commercial banks and the structural changes in the domestic housing market greatly facilitated access to credit and triggered aggressive competition between the publicly owned banks and privately owned commercial banks. Because of limited support from other aspects of macroeconomic policy, monetary policy was placed under inordinate strain. Consequently, the negative side effects of monetary policy were exaggerated more than necessary. This emerged in an unusually large interest rate differential with abroad, with the associated currency appreciation fuelled by carry trade. Fiscal policy that would have been more directed towards attaining the inflation target would have served to offset these negative side effects and help stabilize the economy. More Government support of the Central Bank inflation target ought to have enhanced the target’s credibility. Monetary and fiscal authority changes The Central Bank of Iceland’s inflation target is based on annual inflation in terms of the headline consumer price index (CPI), as measured by Statistics Iceland. This is consistent with almost all other inflation- targeting countries, although it is also common to monitor various measures of underlying inflation. The idea behind such measures is to exclude volatile items, items that reflect supply shocks, or those beyond the influence of monetary policy. This is important in small and open economies where terms of trade shocks can have large effects on the price of imported goods and services, and, therefore, on the CPI. The global economic crisis has also shown the importance of accumulating war chests through fiscal surpluses in good times to support the economy in downturns (Gali & Monacelli 2008, 126). To create this extra fiscal space larger surpluses than were not previously considered need attention. This important element for creating a credible framework for dealing with a large public debt that emerged after the financial crisis. This is important to not only ensure fiscal sustainability, but also for the effective achievement of the inflation target. In order to make fiscal policy more effective and improve its ability to support monetary policy, a number of considerations in the fiscal framework need attention. It is necessary to examine whether it might be beneficial to follow the example of neighboring countries and establish an independent institution that appraises the cost of budget plans and evaluates whether they are consistent with the objective of fiscal sustainability, both at the national and local level (Leeper 2010, par 2). Such an institution could advise the Government on stabilization policy measures to reduce the likelihood of repeating the mistakes of the recent past. Other improvements, such as adopting well defined fiscal rules, can also be helpful, as such, rules can improve the transparency of fiscal decisions and increase fiscal policy accountability. This should bolster the reliability of measures to contain the large public debt, but it can also improve monetary policy transmission. Introducing nominal rather than real expenditure targets, as in the Government-IMF economic program, is also an important improvement. Setting expenditure targets that are consistent with the inflation target increases the effectiveness of automatic fiscal stabilizers. It also helps in strengthening the official ownership of the inflation target, which serves to enhance its credibility and help monetary policy delivering the inflation at target (Leith & Wren-Lewis 2006, 1543). Conclusion It is important that the authorities consider the long-term effects of the austerity measures that have proven necessary in the wake of a sharp increase in public debt following the financial crisis. According to a number of studies and experiences of other states, it is possible to achieve a more sustainable success in reducing the public debt through expenditure cuts rather than tax hikes. The most efficient in reducing the debt burden is through economic growth, to the extent that it is not leveraged and in excess of the country’s output capacity. Increased taxes, however, can reduce the incentive for revenue creation, especially if they are imposed on elastic tax bases. Thus, measures focusing on the revenue side of public sector finances could weaken long-term potential output than expenditure side measures. Therefore, other things being equal, expenditure-based measures could prove successful and efficient in the end than tax-based measures. References Dixit, A. & Lambertini, L., 2001. Monetary-fiscal policy interactions and commitment versus discretion in a monetary union. European Economic Review, 45, pp.977–987. Fragetta, M. & Kirsanova, T., 2010. Strategic monetary and fiscal policy interactions: An empirical investigation. European Economic Review, 54, pp.855–879. Gali, J. & Monacelli, T., 2008. Optimal monetary and fiscal policy in a currency union. Journal of International Economics, 76, pp.116–132. Leeper, E.M., 2010. Monetary science, fiscal alchemy. October. Leith, C. & Wren-Lewis, S., 2006. Compatibility between monetary and fiscal policy under EMU. European Economic Review, 50, pp.1529–1556. Scharpf, F.W., 2011. Monetary Union, Fiscal Crisis and the Preemption of Democracy. SSRN Electronic Journal. Stiglitz, J.E., 2001. Monetary and exchange rate policy in small open economies: the case of Iceland. Central Bank of Iceland Working Papers. Woodford, M. & WALSH, C.E., 2005. INTEREST AND PRICES: FOUNDATIONS OF A THEORY OF MONETARY POLICY. Macroeconomic Dynamics, 9.  Read More