Lessons for Iceland from the Monetary Policy of Sweden

The purpose of this report is to derive lessons from inflation targeting in Sweden for the choice of the future monetary policy regime of Iceland. Swedish inflation targeting has been a success in terms of reducing inflation and inflation volatility, but real economic volatility is not lower compared to previous periods. In addition, financial imbalances have grown rapidly. A key lesson is that the Riksbank has closely shadowed the policy of the European Central Bank due to financial integration. In other words, the Riksbank has behaved as if Sweden had a fixed exchange rate to the euro. Our analysis clearly indicates that a small economy cannot pursue an independent monetary policy from the rest of the world in a financially integrated world. Consequently, we suggest a fixed exchange rate arrangement for Iceland, preferably through a currency board. A currency board would provide exchange rate and price stability. A currency board would require domestic reforms to enhance price and wage flexibility as well as proper regulations on the financial system to minimize the risk of future banking crises.