Monetary policy and the financial crisis in Iceland

Abstract

This paper describes the monetary policy framework in the years 2001-2008, discusses the weaknesses that were revealed during these years and proposes changes that should increase the effectiveness of monetary policy in the future. The central bank should be given both more instruments as well as objectives. Its mandate should include reigning in the expansion of credit in good times, as well as private sector leverage in addition to aiming at an inflation target. The system of housing finance should be changed so that central bank interest rates affect mortgage rates and foreign currency loans to firms and individuals who do not have revenues in foreign currency should be banned. In addition, the monetary authorities should raise capital requirements when banks are deemed to be too big or expanding too rapidly; the authorities should be able to tax banks that are borrowing short term in the wholesale market; they should be able to tax borrowing by individuals and firms and/or reward them for paying down their debt; lower the maximum loan to price ratio in the housing market in a housing boom; and the central bank should actively engage in the currency markets to reduce volatility. Finally, the activities of commercial banks and investment banks should be separated.