Monetary and exchange rate policy in small open economies: the case of Iceland

This paper discusses monetary and exchange rate policy and the financial risks that are involved for small open economies in the current environment of less restricted and increased volume of global capital movements. It then goes on to analyze the policy interventions that are available to reduce and manage these risks. The specific case of Iceland is discussed within this framework. While it might be preferable if the problems posed by global financial instability are addressed by reforms in the global financial architecture, significant reforms are not likely to emerge in the near future. In the meanwhile, countries such as Iceland must take responsibility for their own welfare by managing these risks. That entails actions that reduce the likelihood of a crisis occurring and that reduce the costs incurred when the crisis occurs. Tax and regulatory policies (including financial sector regulation and disclosure regulation) can and should be used both to reduce the likelihood of a crisis and to help manage the economy through a crisis. Such regulations can affect short-term capital flows, which have been at the center of recent crises. There are arguments for the use of price-based interventions and controls imposed through prudential banking regulations. But reducing the risks faced by a country requires even more extensive action: it entails focusing on appropriate bankruptcy codes, exchange rate regimes, and designs of financial systems.