The implementation of monetary policy and the efficiency of the money markets

Since March 1998 the Central Bank of Iceland’s main instrument has been the interest rate on its repos with credit institutions. Until spring 2001 the Bank used this rate to maintain the exchange rate of the króna within its deviation band. After moving on to an inflation target that spring, the Bank has applied its policy rate towards maintaining the target. Changes in the Central Bank policy rate are transmitted to the economy through the financial markets. The policy rate affects other money market rates, which in turn impact the exchange rate of the króna, asset prices and bank lending. These aggregates ultimately affect demand in the economy, inflation expectations and the rate of inflation. The transmission mechanism of monetary policy is described in Pétursson (2001). An important element in the transmission mechanism of monetary policy is the relation between the Central Bank policy rate and other short-term money market rates. In other countries, short-term money market rates track Central Bank rates extremely closely. Chart 1 clearly shows that overnight rates in Canada have been virtually identical to the Bank of Canada’s key policy rate for almost every single day Jón Steinsson1