Stabilizing Inflation in Iceland
This paper provides some empirical estimates on how tightly is it feasible to control inflation in a very small open economy such as Iceland. Estimated macroeconomic models of Canada, Iceland, New Zealand, the United Kingdom, and the United States are used to derive efficient monetary policy frontiers that trace out the locus of the lowest combinations of inflation and output variability that are achievable under a range of alternative monetary policy rules. These frontiers illustrate that inflation stabilization is more challenging in Iceland than in other industrial countries primarily because of the relative magnitudes of the economic shocks.
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Estimation Results for Iceland Model with Fiscal Policy
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0.20 inverse gamma 2005Q2 Parameter Prior aggregate demand Bank’s Beta Canada Central Bank coefficient on inflation coefficient on ygap deviation measurement error Distribution Posterior Mean economy efficient frontiers efficient policy frontiers equilibrium value error ygap 0.20 Errors Sample period fbgap foreign sector GDP and Potential Iceland Inflation and Target inflation-output variability trade-off Interest Rate Gap interest rate variability inverse gamma 0.139 lag inygap Log GDP Mean Distribution Posterior measurement error ygap monetary policy reaction output gap Parameter Prior Mean policy reaction function policy rules Posterior Mean Domestic prior distributions Prior Mean Distribution Rate and Equilibrium real exchange rate real interest rate Real Short-term Interest Rest of World rrgap inygap Sample period 1992Q2 Short-term Interest Rate standard deviation measurement stochastic error process target band target rate tolerance band tolerance range tolerance-range breaches tt t tt United Kingdom volatility Y-o-Y CPI Inflation ygap 0.20 inverse ygap ygap rrgap Zealand ξπ ρπ