Second, they can buy assets – which, in this hypothetical economy, means cars – increasing demand for them and hence their price. These actions lower the cost of borrowing and raise the price of assets in the two-car economy. Both support the production of cars by firms and the consumption of cars by households. In this way, aggregate activity in the economy is boosted, at least in the short run. By lowering interest rates and purchasing assets, a central bank can help meet its mandate of supporting the economy as a whole. If the aggregate impact of looser monetary policy on the economy is positive, what about its distributional impact across regions? In this simple setting, lower interest rates boost the incomes of net borrowers in Red Car region, while reducing the income of net savers in Blue Car region. As the income of Red Car consumers is lower than Blue Car consumers, this shrinks the distribution of incomes across the economy. The effect of asset purchases is to boost the wealth of all car owners, with the bigger boost felt by those whose car wealth is largest. So although both regions are better off in net wealth terms, Blue Car region benefits more than Red Car region. Put differently, the distribution of wealth across regions may widen as a result of asset purchases. Or that at least is what this simple, stylised economy would imply. 3  The Real Economy Now let’s return to planet earth, from the hypothetical to the real world.
The remuneration schemes in financial undertakings and the decisions made by credit rating agencies added fuel to the fire. Financial supervisors tended to focus on risk attached to individual financial institutions more than on system-wide risk. There was also a tendency to practise somewhat lax supervision in order to stimulate the development of financial centres. As a result of all of the above factors, the financial system became far too leveraged. At this writing, a variety of efforts are being made internationally towards correcting these flaws, as is described more fully in this report. The Central Bank of Iceland is following these developments closely, not least through its membership in the Bank for International Settlements in Basel, which is the venue for a number of the committees and institutions that assess risk in the global financial system and formulate the regulatory framework and standards that govern it. The experience of this financial crisis – both in Iceland and abroad – calls for a reassessment of the most effective architecture for financial supervision, with particular emphasis on the nature of the relationship with the central bank. For some time, the trend was towards separating central banks from financial supervision, particularly in countries with developed financial systems. But as is discussed in this Financial Stability report, banking supervision has remained within the central banks of a majority of European countries, and the pendulum might be swinging in that direction once again in countries with developed financial systems.