Examples include the troubles encountered by banks in Finland, Norway and Sweden a decade ago and the crises that hit Asia and Latin America in the latter part of the 1990s. The Central Bank of Iceland has now built up a new organisational department, the Financial Stability Department, which has the main role of monitoring factors affecting financial stability. Twice a year the Bank publishes articles on this topic in its quarterly Monetary Bulletin, an annual main study in May and a shorter account in November. In addition, the Central Bank and Financial Supervisory Authority maintain close and productive cooperation, each seeking to ensure the security of the Icelandic financial system in its respective way. Inflation targeting To return to monetary policy itself, we should recall the joint declaration on the inflation target and changed monetary policy which was issued on March 27 by the Government and the Central Bank of Iceland. See the Central Bank of Iceland’s Monetary Bulletin 2001/2 With this declaration, the monetary framework was changed and inflation targeting was adopted, whereby the fixed exchange rate with fluctuation limits was replaced by a floating exchange rate. The inflation target was set at 2½%, measured as the twelve-month rise in the CPI. The declaration stated that if inflation deviated by more than 1½% from this target the Bank was obliged to bring it back within the tolerance limits as soon as possible.
In sum, the recurrence of financial crises, the emergence of market distortions and the new challenges facing supervisors have prompted some analysts to wonder whether there would exist a dilemma between efficiency and stability. Is instability the price to be paid for the improved efficiency resulting from financial deregulation? Allow me to present now the answers I think central banks and prudential authorities could give to these questions. 3. Monetary and prudential policies should promote an environment in which financial systems are both stable and efficient  First, monetary policy should act as a stabiliser Monetary policy alone cannot guarantee the stability of financial systems, which may be jeopardised by shocks from both the financial and the real economies. However, it does have a stabilising effect. In general, the objective of price stability lowers economic agents’ uncertainty regarding future price developments. In addition, by committing itself to a long-term objective, the central bank reduces market uncertainty, which can be a source of disruption to the financial economy. Interest rates are less volatile as a result, which is of benefit to the long-term growth of the economy. To achieve this, the central bank must send clear and consistent signals to agents and markets and maintain a constant exchange of information. Financial innovation and the liberalisation of capital movements have made such communication more sensitive. Central banks must now systematically explain discrepancies between actual and projected results if they are to preserve their credibility.