In the current world environment, there are less economic restrictions across borders and the volume of capital transfer from one country to another is increasing. As a result, exchange rates have become important economic policies in various countries. Exchange rate policy may therefore affect the monetary policy of various countries. Specifically, small open economies exhibit an enormous interaction between exchange rates and monetary policies as their central banks attempt to develop monetary policies that independent monetary policies. Policymakers establish a tradeoff between fixed exchange rate and independence of monetary policy by establishing the role played by exchange rate in monetary policy. This essay will discuss monetary and exchange rate policies in relation to Iceland, a small open economy. Iceland is an extreme case of a small open economy because it has a population of about 315,281 people, a GDP of $13.05 billion (in 2012) and a foreign exchange turnover of $4.192 billion.
There are various theoretical perspectives of the relevance of exchange rates for monetary policy making. Determination of exchange rate provided by various models indicates that there are some effects of monetary policy making on exchange rate, especially in terms of money aggregates. Rapid rates of monetary expansion caused by monetary policy making in a small open economy depreciates nominal exchange rates given that the demand for money remains constant (Banbula et al, 2012). Most economic theories suggest that an increase in a country’s monetary growth would be reflected by the price levels of the economy in the long run. In turn, the increase in price levels in the economy is offset by exchange rate depreciation. Due to the acts and consequences of monetary policy making, interest rate changes in the short run have expected effect on exchange rates.
In small open economies like Iceland, foreign policy changes affect exchange rates in two ways: through interest rates and expectations, and through their impact on relative macroeconomic conditions – inflation and current account. Increase in foreign interest rates caused by monetary policy changes results in downward pressure on exchange rates and capital outflows (Banbula et al, 2012). If a country engages in monetary policy making that targets monetary aggregates, an increase in foreign interest rate may cause depreciation of the country’s currency. As a result, aggregate demand and prices will increase; hence the demand for money will also increase.
Some theoretical arguments also suggest that independent monetary policy making and exchange rate stability cannot be achieved simultaneously (Xiaolian, 2010). It is therefore possible for a small open economy like Iceland to sacrifice monetary policy independence in order to pursue exchange rate objectives. Countries that have high demand for imports rely on exchange rate to ease inflationary pressures. However, this depends on the exchange rate regime used by a given country. Xiaolian (2010) suggests that flexible exchange rate regime can be used in monetary policy making to reduce inflation and asset bubbles. Flexible exchange rate regime also improves monetary policy transmission mechanism and enhances the effectiveness of monetary policy making.
When inflationary pressures rise in a country, strong domestic currency can be used to reduce prices of imports. Therefore, exchange rate is an important tool in monetary policy making. Exchange rate is one of the price tools that can be used to adjust trade and BOP imbalances in small open economies (Lubik and Schorfheide, 2007). Use of exchange rate in monetary policy making reduces foreign exchange inflows and build-up of reserves. It also promotes sustainable economic development and stability of money supply.
Monetary policy is characterized by Inflation Targeting (IT) which can be highly affected by exchange rates. Inflation targeting as a form of monetary policy has three key features which may be influenced by exchange rates. The three features are: establishment of a numerical inflation target, policy implementation based on the forecast target, and high level of transparency and accountability. Exchange rate affects inflation in some ways. Movements in exchange rate affect CPI inflation because some of the goods that affect the CPI are produced in foreign countries (Sarno, 2005). Fluctuations of exchange rates also affect inflation in various ways. For instance, depreciation of local currency may lead to higher costs of production in the domestic market because the prices of imported inputs will increase if the local currency depreciates. Depreciation of local currency also leads to higher demand for domestic goods by foreigners and expectation of growth in wages.
Exchange rate is also important in monetary policymaking due to its informative value. In some cases, especially in small open economies, it may be difficult for the central bank to observe the state of the economy. In this case, exchange rate may be used as a directly observable and forward-looking variable to determine the state of the economy. In other words, exchange rate may act as a lead indicator in establishing the state of the economy. Exchange rate can therefore be used as a tool of determining interest rates as part of monetary policy. Interest rates control the levels of inflation in the economy, and exchange rates have impact on such interest rates established by central banks.
The empirical and policy issues related to monetary policy making and exchange rate can be analysed using an example of a small open economy. Iceland is one of the small open economies whose monetary policy making is influenced by exchange rates.
Small open economies experience various problems that necessitate sound monetary policy making. The 2008 global financial crisis and 2011 Eurozone debt crisis caused substantial problems to small open economies in Europe and other parts of the world. Investor sentiments have changed and caused destabilization of capital flows. It also caused high interest rates on affected countries, including those that practice prudent macroeconomic policies. The global financial crisis has changed the way of thinking in terms of macroeconomic and structural policies of small open economies.
Iceland is one of the small open economies that have been most affected by the global financial and debt crisis. Iceland is vulnerable to crises due to the high volatility of currencies such as Yen, Dollar, and Euro. Iceland has problems in risk management trading with currencies such as Euro. Changes in exchange rate in small open economies cause adverse macroeconomic effects in such economies due to limitations of risk diversification (Stiglitz, 2001). Exchange rate swings cause bankruptcy or corporate distress in small open economies. Such problems of the corporate sector can be transmitted easily to the financial system.
Iceland faces many problems faced by many other small open economies. The problems of the country were heightened in the aftermath of capital market liberalization. Although the country pursues key monetary and fiscal policies, its current deficit of -$740 million (2012) places the country in position 112 in the world in terms of current account deficit (CIA, 2013). The debt crisis can be attributed to the credit crunch of Europe which has caused the country to finance its debts through foreign borrowing.
Iceland adopted a flexible exchange rate and adopted inflation targeting in 2001 (Stiglitz, 2001). These two moves indicate a relationship between exchange rate and monetary policy making as a way of solving macroeconomic problems in the country. The financial sector of Iceland collapsed in 2008 due to the global financial crisis that resulted in the depreciation of Krona (the country’s currency). Due to the collapse of the financial sector of the country, monetary policy making became one of the essential steps to restore the economic stability of the country. One of the monetary policies adopted was inflation targeting. Another policy was stabilization of Krona (Stiglitz, 2001). Stabilization of Icelandic krona after its depreciation following the global financial crisis helped to reduce the current account deficit.
Restructuring of the banking sector also helped Iceland to improve its money supply and reduce foreign debts of the country. Capital flows were also stabilized using taxes, disclosure and regulatory measures. The banking sector has been the major focus in monetary policy making of Iceland. After the collapse of three of the major banks of Iceland in 2008, specific measures have been taken to maintain the liquidity of financial institutions in the country. Following the financial crisis of 1997, the central bank of Iceland in initiated minimum liquidity requirements on credit institutions (Stiglitz, 2001). This improved the net foreign assets position of the financial sector. Furthermore, net exposure to foreign exchange was limited to 30% of the total capital base of the banks (Stiglitz, 2001). This monetary policy requires the relevant authorities to consider the exchange rate in order to make such limitations on foreign exchange reserves of banks.
In conclusion, it is apparently clear that exchange rate is relevant in monetary policy making. This is because the strength of foreign currencies determines the price levels, inflation and interest rates of a country. Theory suggests that an increase in monetary growth as a result of monetary policy making results in depreciation of nominal exchange rate. As a result, some foreign debt and financial problems can be solved. Iceland is one of the small open economies whose monetary policy making has influenced exchange rates. Inflation targeting and financial institutions’ restructuring has enabled the country to stabilize its exchange rate. Therefore, exchange rate has some relevance in monetary policy making in small open economies like Iceland.
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