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Too Little, Too Late? Testing The Optimality of Monetary Policy in Iceland

Author

Listed:
  • Birta B. Haraldsdottir
  • Bjarni G. Einarsson

Abstract

We apply a sufficient statistics framework to detect nonoptimal monetary policy decisions in Iceland. The method relies on two sufficient statistics: (1) forecasts of policy objectives and (2) impulse responses of those objectives to monetary policy shocks. The weighted product of these two sufficient statistics forms the gradient of the policy maker’s loss function. The Optimal Policy Perturbation (OPP) statistic, derived from this gradient, provides the test for optimization failures. Our results suggest that the Central Bank of Iceland’s key interest rate has, on average, been set too low over the past two decades. There are two notable deviations from optimality: the periods leading up to the financial crisis and following the Covid-19 pandemic.

Suggested Citation

  • Birta B. Haraldsdottir & Bjarni G. Einarsson, 2026. "Too Little, Too Late? Testing The Optimality of Monetary Policy in Iceland," Economics wp101, Department of Economics, Central bank of Iceland.
    • Handle: RePEc:ice:wpaper:wp101
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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E65 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Studies of Particular Policy Episodes

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