BIS central bankers’ speeches  9  •  Possible improvements to the monetary policy framework, including a longer target horizon for policy formation, which offers greater flexibility to take account of longer-term risks to price stability, including those due to financial stability risk. •  Changes to the financial system should also aim at improving monetary policy transmission. This option has the advantage that Iceland retains monetary independence and a flexible exchange rate and can therefore respond to future idiosyncratic shocks. Another advantage is that a domestic run on the Treasury and/or solvent banks would be manageable. Furthermore, there is reduced risk of financial instability due to excessive capital inflows and a subsequent run on the external funding of the banking system and the Treasury. The disadvantages of this option lie in the fact that the possibilities for external trade without exchange rate risk will remain limited, and the domestic financial system will continue to be more expensive and less integrated with the global financial system than it would otherwise be. In that case, prudential rules restricting domestic financial institutions’ cross-border operations will be needed. The feasibility of this option is also dependent on support for the necessary reforms. But even though that condition is fulfilled, it is not likely that excess exchange rate volatility will disappear, as it is also rooted in the inherent volatility of asset prices and the small size of the domestic foreign exchange market.
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.