Iceland: Challenging Times for Monetary and Fiscal Policies

Abstract

Monetary and fiscal policies face huge challenges: the banking sector has collapsed; the economy is in the midst of a deep recession; the exchange rate has plunged; capital flows have been frozen; inflation is elevated; public debt has risen; source of revenues have disappeared; social needs have increased; and the unemployment insurance fund has been nearly depleted. Against this difficult background, this paper discusses what policy makers should do in order to restore balance in the Icelandic economy and lay out the foundations for a sustainable recovery. The key recommendations are to seek entry in the euro area and implement the fiscal consolidation measures necessary to comply with the IMF programme.

Keywords: inflation, volatility, inflation targeting, exchange rate targeting, inflation expectations, policy credibility, capital controls, EU, euro area, optimal currency area, fiscal consolidation; taxes, public-sector wages, public investment, fiscal policy framework, efficiency of social spending

JEL Classification: E21, E42, E52, E62, H51, H52, H60