1.5  Exchange rate targeting and adoption of another currency  In some respects, the structure of the Icelandic economy calls for a flexible exchange rate. Offsetting this are excess exchange rate volatility and studies indicating that the Icelandic króna has tended to be a source of shocks more than a shock absorber. Furthermore, there are various benefits of euro area membership through EU accession, such as increased international trade and access to a deeper financial market without exchange rate risk. But if EU membership proves not to be an option – for instance, if an acceptable solution to the euro area crisis cannot be found and/or if a majority of the electorate is opposed to it – and Icelanders are either unable or unwilling to address the pre-crisis flaws in monetary and economic policy without sacrificing exchange rate flexibility, other options should be examined, such as some type of exchange rate targeting or unilateral or bilateral adoption of another currency. These options are discussed in Chapters 18 and 19, while Chapter 20 focuses on the issues that must be considered in selecting a currency to adopt or use as an anchor. Exchange rate targeting entails defining limits on exchange rate movements and applying monetary policy so as to keep the exchange rate within that band. Such bands can vary in width, the commitment to the exchange rate target can vary in strength, and the commitment can be backed by other declarations and policy actions that further support the target.
The króna is now worth only 0.05% of its value prior to the 1922 devaluation; in other words, it has depreciated by 99.95%. In terms of consumer prices, the króna has eroded in value even more, or about 99.99%. In other words, its purchasing power in terms of goods and services is currently only 0.013% of what it was in June 1944, when the Republic of Iceland was founded. Nevertheless, over this period, Iceland developed from being one of the poorest countries in Europe to one of the richest in per capita terms, despite the economic costs of persistent inflation. Currency depreciation and subsequent inflation episodes have sometimes expedited the necessary adjustment following economic shocks, however, thereby returning the economy more quickly to a path of economic growth. Chapters 3 and 12 focus on certain aspects of Iceland’s experience with an independent currency. In Chapters 9 and 13, two key questions are asked. First, how effective is monetary policy in achieving the goals with which it is tasked? Second, has the flexibility of the exchange rate facilitated economic adjustment and stability, or has it instead been a source of shocks? Summarising these findings reveals that Iceland’s experience of independent monetary policy and a flexible exchange rate has been poorer than that in many other countries, in that monetary policy has not been successful in achieving its goals and the flexible exchange rate has tended to be a source of shocks rather than a shock absorber.