The interest rate r is set to minimise fluctuations in the economic cycle and inflation E∑  [(  −  ∗  ) +  (  −  ∗  ) ],  while c is set to stabilise the financial cycle E∑  [  −  ∗  ]. A theoretical result is that coordination, that is, alternative A, is in general preferable to separating the two types of policy. The reason is that alternative B is a special case of A. A policy-maker who can choose both r and c to stabilise both economic activity and inflation as well as the financial cycle (or two policy-makers who can fully coordinate their decisions on r and c) always has the possibility to separate the decisions, that is, to go from A to B. A should therefore not reasonably be able to lead to a poorer result than B. This does not necessarily mean that coordination is always a good idea in practice. It may be the case that, in reality, there are costs linked to coordination that can be reduced or avoided if one separates the decisions on monetary policy and macroprudential policy. For instance, it may be more difficult to evaluate and forecast economic policy if different instruments are used at the same time to try to attain different targets.8 A related argument in favour of separating both types of policy concerns the risks of a decline in confidence in monetary policy.
The number of countries that have adopted an inflation target for their monetary policy implementation has increased sharply after New Zealand introduced such a policy in February 1990. In all, 21 countries have now moved onto a formal inflation target, including Canada, the UK, Norway, Sweden, Switzerland and Australia. In most countries this has greatly stimulated discussion of monetary policy; central banking and central bank policies and measures are more in the spotlight and public debate than before, although of course opinions about them are divided as ever. One consequence of this policy is that exchange rate stability is no longer the anchor of monetary policy. This is not because the exchange rate of any currency is a lightweight factor in economic developments; rather, experience has shown that in a climate of unrestricted cross-border capital flows, central bank instruments are inadequate for maintaining a stable exchange rate. When crossborder capital flows are unrestricted, a central bank’s primary instrument is interest rates, which in the long run can only attain a single macroeconomic goal, i.e. ensuring price stability. It has turned out that other countries have benefited from adopting such a framework. It was in light of this international experience that the Central Bank of Iceland’s monetary policy framework was changed two years ago and formal inflation targeting was adopted.