Monetary transmission in Iceland - Evidence from a structural VAR model

This paper analysis the transmission mechanism of monetary policy in Iceland using three alternative identification schemes in a structural VAR setting. Consistent with the international literature, we find that an unexpected monetary policy tightening leads to a temporary but sizable contraction in output, a sustained appreciation of the nominal exchange rate, and a more sluggish and persistent decline in inflation. Three other structural shocks are also identified. All have plausible economic interpretation and can explain the bulk of the variation in output and inflation over our sample period. By comparison, the contribution from monetary policy shocks is relatively modest, especially to output fluctuations. Historical decomposition shows, however, that monetary policy played an important role during the disinflation of the second half of the 2010s and in offsetting a large negative demand shock following the global pandemic at the start of this decade. However, the historical decomposition also suggests that the withdrawal of the post-Covid monetary easing was too slow, thus contributing to rising inflation by the end of the sample period.