| Summary: | Global financial integration intensified in the period leading up to the Great Financial Crisis, as was witnessed by the growth of cross-border banking, capital flows, and gross external capital positions. For small, open economies (SOEs) that have lifted restrictions on capital movements, global financial integration seems to have undermined the scope for independent monetary policy, even if these countries had adopted a flexible exchange rate regime. Monetary policy transmission was weakened through the interest rate channel, as long-term rates in SOEs became increasingly correlated with long rates in large, advanced countries. The exchange rate channel was unstable, however, with exchange rates diverging from fundamentals as uncovered interest rate parity failed to hold over relevant periods and capital flows were volatile. These tendencies can contribute to monetary and financial instability when they interact badly with other economic and financial risks that can face small, open, and financially integrated economies. This was the case in Iceland. A fundamental rethinking of policy frameworks and tools has been underway in SOEs in the wake of the crisis. Potential policy instruments include foreign exchange intervention, enhanced prudential rules on foreign exchange risks, macroprudential tools, better alignment of fiscal and monetary policy, and even selective capital flow management tools. Capital flows, exchange rates, financial integration, financial stability, monetary policy
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