Inflation and disinflation in Iceland

Abstract

Iceland was a high inflation country from the second half of the seventies and until the middle of the eighties. During the middle of the nineties inflation in Iceland, at less than 2% p.a., was among the lowest in the OECD. In this paper we analyse the roots of high inflation in Iceland and the subsequent disinflation episode. We find that high inflation in Iceland was caused by an increased frequency of external shocks, a tight labour market and a stronger devaluation bias. We further find that disinflation took place in two stages. The first was initiated in 1983 by a policy package of statutory incomes policy and a firmer commitment to exchange rate stability as a response to an inflation crisis. It reduced inflation from the high to the moderate range at negligible cost in terms of output and employment. The second stage took place during the early nineties and reduced annual inflation from the moderate range to below 3%. It involved more fundamental changes in policy priorities and public attitudes than the first stage and is more unique in the international context. It was also more costly in terms of output and employment than the first stage, although the costs seem to have been rather small compared to some other countries. A relatively high degree of real wage flexibility, the use of incomes policy, widespread financial indexation and, above all, a broadly based consensus that the general public was best served by low inflation all contributed to this outcome.