Iceland and the financial crisis: Would EMU-membership have helped?

• Main Author: Olsson, Erik
• Format: Other/Unknown Material
• Language: English
• Published: Lunds universitet/Nationalekonomiska institutionen 2015
• Subjects: Iceland; financial crisis; euro; EMU; interest rate; Business and Economics; Downfall
• Online Access: http://lup.lub.lu.se/student-papers/record/7793252

After the global financial crisis erupted in the fall of 2008 the Icelandic economy was thrown into recession. It has been suggested that Iceland would have been better off had it been a part of the EU and the European Monetary Union (EMU) and this essay aim at investigating that claim. Entering the EMU entails losing the ability to carry out an independent monetary policy. Therefore I have estimated a model of the relationship between the real interest rate and GDP growth rate in Iceland and also included a parameter for the relationship between exchange rate fluctuations and GDP growth rate. My result suggests that with the interest rate of the European central bank (ECB), GDP growth in Iceland would have been around 0.6 percentage point higher in 2006 and 2007 and 0.8 percentage point in 2008. With the already high growth rates and credit growth in the Icelandic economy during these years this would have posed a risk of an even larger overheating, and subsequently an even deeper downfall into recession in 2009. Part of this downfall would have been offset by the fact that ECB continued to pursue a much more expansionary monetary policy than the central bank of Iceland also in 2009. In my model I cannot establish a significant exchange rate effect on GDP. This suggests having the euro would not have had a significant effect on the recovery of the Icelandic economy.