As long as economic resources are mobile this is  Chart 8a: In the short run there are diminishing  probably a reasonable thing to do. When thinking  returns to scale  about what determines supply capacity at the level of an individual sector we generally think the process exhibits what are called “constant returns to scale”. If you double all the resources involved you double potential output. So in Chart 8a the response of output to demand looks like a straight line. And the nice thing about this is that, if we add up demand across a lot of sectors it doesn’t matter what the distribution of that demand looks like. Demand in individual sectors can move anywhere along that straight line and all that will matter for total output is the total amount of spending5. But economic resources aren’t perfectly mobile, not in the short run at least. Even if people can move relatively quickly from one job to another, it takes time to repurpose a building and to retrain an employee. And when some of those capital resources are slow to move supply looks more like the curved line in Chart 8a: there are “diminishing returns to scale”. This implies that shifts in demand can, even for a given aggregate, lower aggregate supply. Chart 8b is meant to get this across. Suppose two sectors start with the same level of demand D and that they each have the right level of resources.
The Central Bank’s effective policy rate has fallen from 18% (the seven-day collateralised lending rate) at the beginning of 2009 to the current 4½% (the average of the current account rate and the maximum CD rate), and is now at an all-time low in the nearly 50-year history of the Central Bank of Iceland. Progress has also been made in improving Iceland’s external liquidity position by expanding the foreign exchange reserves, which reduces concerns about the Treasury’s ability to service its foreign debt in coming years. Repurchases of the Treasury’s foreign debt have also helped. The foreign exchange reserves exclusive of short-term obligations could quickly grow to over 3 billion euros, if Iceland draws in full on the loans contingent upon the third IMF review and when payments on the Avens agreement and the sale of Danish bank FIH are remitted. In comparison, the Icelandic Treasury’s payments of instalments and interest on two bond series maturing in 2011 and 2012, less repurchases, amount to 1.1 billion euros. This positive development explains the relatively upbeat outlook of foreign bankers and analysts towards Iceland, as could be discerned at the annual meetings of the IMF. It also explains why the CDS spread on sovereign debt has fallen in recent months and now lies below that of the European countries whose public debt problems have dominated business media recently. But we have to do better if Icelandic companies are to gain access to foreign credit markets on acceptable terms.