Iceland: High Growth, Low Inflation and Current Account Surpluses: What's behind this Remarkable Performance?

Iceland currently features an impressive combination of favourable macroeconomic indicators, such as high output growth, low inflation and current account surpluses. This is in stark contrast to 10 years ago, when Iceland's economy was at the brink of collapse, suffering from a major banking crisis which erupted with the bursting of the 2007-2008 financial sector bubble. This country brief explores the main factors behind Iceland's remarkable economic recovery. Among others, the paper also analyses whether Iceland's sharp exchange rate depreciation in the wake of the crisis and its appreciation during the recovery has helped to smoothen the country's output fluctuations. The paper uses structural Vector Autoregression (VAR) estimates to assess the impact of exchange rate fluctuations on Iceland's economy. Key ingredients for Iceland's strong economic performance have been a solid crisis response by Iceland's authorities, addressing the roots of the problem, and a flexible supply response, in particular on the labour market, which allowed accommodating a substantial positive external demand shock (tourism). Furthermore, the tourism-driven strong demand for Iceland's currency, the króna, supported an exchange rate appreciation, which helped to contain inflationary pressures. In addition, an increasing savings ratio kept import growth at bay, while the settlement of crisis-related debt helped to improve Iceland's external position. Overall, there have been many different factors contributing to Iceland's impressive recovery. Exchange rate flexibility has been only one of those, and probably not the most decisive one.