the interest terms at which  BIS Review 95/2001  1  financial institutions can borrow short-term capital from them, central banks can influence the volume and price of liquidity in the financial system. Central Bank interest rate decisions have an impact on short- and long-term interest rates, financial system liquidity, money in circulation and bank lending, exchange rates of currencies, other asset prices and, last but not least, market participants’ expectations about the future development of all these factors. All this, in turn, influences consumption and investment decisions of individuals and businesses, and thereby aggregate demand. The impact in individual areas can vary greatly from one time to the next. The new Central Bank Act The previous Central Bank Act dated from 1986 and was drafted over the period 1981 to 1984. It was a product of its time and did not reflect the perspectives that later established themselves. In the early 1990s the then Minister of Commerce appointed a committee to review the Central Bank Act, chaired by Professor Ágúst Einarsson, the current Dean of the Faculty of Economics and Business Administration. Following the committee’s work the Minister of Commerce proposed a bill to parliament for a new Central Bank Act which entailed sweeping changes from the 1986 Act, including what are now considered to be many of the necessary elements of central bank legislation. However, the bill was not adopted by parliament.
The policy rate is the rate of interest applying to the Central Bank’s repo transactions with credit institutions, i.e. interest on liquid funds that they borrow from the Bank. Monetary policy has been the subject of lively debate in recent weeks and months and the Bank has been under steady pressure to cut interest rates. As the Central Bank has repeatedly underlined, its viewpoint has been that lowering interest rates entails a greater risk than waiting for a while for tangible signs that the assumptions behind the August inflation forecast will hold good. It is crucial to bring inflation down swiftly, since it goes without saying that inflation is the worst enemy of both households and businesses. A tight monetary stance inevitably has consequences which are sometimes painful for households and businesses. There is nothing to be done about that. Households and businesses alike must accept the consequences of their actions and it is obvious that many of them have simply gone to excesses in their consumption, investments and borrowing in recent years. They will need to reduce their spending, cut costs and put their finances in order. That cannot be avoided. BIS Review 95/2001  3  I also point out that the current account deficit is very large. Even though it has shrunk rapidly this year and will foreseeably continue to decrease substantially next year, it is still very large both in a historical and an international context. In order to achieve acceptable macroeconomic balance, a contraction in national income is unavoidable.