In addition, the Government owns substantial assets that it could sell in order to speed up the reduction of gross debt, including its stake in the banks.6 How Iceland would stand vis-à-vis the other Maastricht criteria, such as those pertaining to inflation, interest rate differential, and ERM II membership (for two years prior to accession) is also largely in the hands of the authorities. Through fiscal restraint, they could also contribute to the convergence of long-term interest rates. The social partners could promote low inflation by exercising restraint in wage settlements. Finally, the shorter end of the interest rate spectrum is determined by the market’s self-fulfilling expectations concerning membership itself and by the decisions of the Central Bank. Although a number of arguments indicate that currency union membership would suit Iceland well, it is not certain that a majority of the electorate will vote in favour of European Union membership in a national referendum. The fact that a number of EU member countries are in  5  Intervention would normally be sterilised in order to prevent undesirable effects on money supply. Hence the impact on the exchange rate is unlikely to be large or lasting. 6  According to current targets, the authorities aim to reduce gross public sector debt to 70% of GDP by 2015. 4  BIS central bankers’ speeches  financial distress, not least those permitted to join the EMU through rather liberal interpretation of the Maastricht criteria, does not increase the likelihood that the referendum would pass.
Not only is exchange rate volatility greater, but the adjustment of the exchange rate returns less than no benefit in the form of a more stable real economy.4  All four of these explanations probably have some validity, but there is good reason to examine the fourth of these more closely. Why is exchange rate adjustment not a shock absorber in small countries, as in the textbook example, but rather a source of shock? There could be a number of explanations for this. 1. The tendency of exchange rates to fluctuate in excess of what appears to be warranted by fundamentals could be a contributing factor. In a sense, the exchange rate of a currency is an asset price and, as such, is determined by expectations visà-vis an uncertain future. Expectations can swing from euphoria concerning the expected future stream of foreign currency revenue from investment that will support a currency to despair and, in extreme cases, serious lack of confidence over a protracted period. Exchange rate movements have a more profound effect on the economy than do other asset prices, however. In addition to storing value, a currency is a unit of account and a medium of exchange. Fluctuations in currency exchange rates induces volatility of relative prices throughout the economy, particularly in small, dollarised economies, and elevate the risk of doing business. 3  Increased aluminium production has also reduced the impact of commodity market volatility on the domestic employment level.