The following are answers to commonly asked questions, together with explanations of various terms and concepts:
Central Bank of Iceland base money (also referred to as the monetary base or high-powered money) consists of banknotes and coin in circulation and deposit-taking institutions’ deposits with the Bank.
The discounted rate is loan interest payable at the time a loan is taken. It is often used in connection with bills of exchange maturing in less than one year.
Economic variables are any type of figures or variables that describe the economy and economic developments; for instance, gross national product (GNP), output growth, inflation, public expenditure, etc.
Exchange rate index
The exchange rate index indicates the average exchange rate of specific foreign currencies against the Icelandic króna. A rise in the index indicates that the price in krónur of foreign currencies has risen. Therefore, a rise in the index represents a decline in the exchange rate of the króna, while a decline in the index represents a rise in the exchange rate of the króna. The exchange rate index is based on a weighted average of a basket of the main currencies used by Icelanders; i.e., the weight of each currency depends on that currency’s share in Iceland’s goods and services trade. This is revised annually to ensure that the currency basket always reflects the composition of Iceland’s external trade as closely as possible. Because of this weighting, the exchange rate index is often referred to as the trade-weighted index (TWI).
GDP and GDP growth
A country’s gross domestic product (GDP) is the total value of all final goods and services produced within the country’s borders. GDP growth (or output growth) is the change in GDP in real terms (that is, at constant prices), usually calculated on a year-on-year basis. A contraction is said to take place when GDP declines between years; i.e., when GDP growth is negative. GDP is not an adequate measure of a nation’s well-being, however, in part because it does not take account of all production. For instance, it does not include production taking place within the household and intended for private use. In addition, no account is given to whether production has a detrimental effect on the environment.
Inflation can be defined as a continuous rise in the general price level. The general price level refers to the average price of goods and services in the market, and not the price of a specific product or type of service. A continuous rise in the general price level refers to a series of increases over a relatively long period of time (such as a year) and not, for instance, within a single month. Inflation entails a decline in the value of money; that is, each króna buys a smaller amount of goods and services. Price level changes are measured using indices. The most common measure of price changes is the consumer price index (CPI). Surveys of domestic household consumption are carried out on a regular basis. Price developments are monitored each month, and the results from the household surveys are used to weight together the prices of individual types of goods and services to produce an overall index. Percentage changes in the index over a specified period – twelve months, for example – are then used as a measure of inflation.
Numismatics is a branch of cultural history and provides important support for other scholarly fields, such as history and archaeology. In many ways, it is related to the study of medals, heraldry, and so forth. The study of numismatics covers all types of currencies issued by companies and institutions. It also includes related items such as commemorative coins, honorary coins, and medals. Numismatics involves the history and analysis of these topics.
Output gap/Output slack
The potential output of the economy is defined as the level of output that is consistent with full utilisation of all of the factors of production: the capital stock, the labour force, and available technological expertise. In the short run, excess demand in the economy can cause actual output to deviate from potential output. When GDP exceeds potential output, an output gap (sometimes referred to as a positive output gap) exists. This generates tension in the economy, which manifests itself in excess demand in the goods and labour markets. This, in turn, causes inflation to rise. If GDP is below potential output, however, an output slack (or negative output gap) develops. Other things being equal, an output slack reduces inflationary pressures.
Overdraft interest rate
The overdraft rate is the interest charged on an overdraft loan; i.e., on the amount that the customer is authorised to withdraw from a bank account even if the balance is insufficient.
Penalty interest is interest calculated on payments in default, as compensation to creditors for delayed payment. Penalty interest is therefore charged as a result of non-performance, where other interest assumes that payment is made promptly.
Prime lending rate
The prime lending rate is the lowest lending rate offered by credit institutions. It is used when, in the credit institution’s assessment, risk is very limited or non-existent.
Real interest rate
Real interest rates are interest rates that take account of changes in the general price level; that is, the change in the purchasing power of money that bears a certain rate of interest. A simple calculation of the real interest rate is the figure obtained by deducting the inflation rate from the nominal interest rate; i.e., the nominal interest rate net of inflation. A more accurate portrayal can be obtained with the Fisher equation:
where r represents the real interest rate, i represents the nominal interest rate, and π stands for inflation. The real interest rate is usually lower than the nominal rate by the amount of inflation. During times of deflation, however, when twelve-month inflation is negative, the real interest rate is higher than the nominal rate.
Rates on the interbank market for krónur. The market for krónur is also known as the REIBOR market, and interest rates in the market are called REIBOR rates. REIBOR is an abbreviation of Reykjavík interbank offered rate.
Returns show how much a given interest rate will yield if interest is paid annually, at the end of the year. This can be shown with an equation assuming that the loan is repaid in full in a lump sum:
where a represents returns as a percentage (%), L is the final payment, H is the initial payment, and d is the number of days until the payment date.
The Central Bank’s foreign exchange position
The foreign exchange position indicates the Central Bank of Iceland’s net foreign exchange assets; that is, the foreign exchange reserves net of short-term FX liabilities.
The Central Bank’s key interest rate
The Central Bank conducts monetary policy largely by affecting money market interest rates; in particular, through the interest rates on the facilities it offers to credit institutions, which then affect other market rates and thereby affect factors such as the supply of money in circulation, demand, and inflation. The Bank’s key interest rate (sometimes called the policy rate) is the rate on these facilities that is the primary determinant of short-term market rates and therefore of the monetary stance. The purpose of raising the key rate could be to reduce lending, overheating, and inflation, or to strengthen the currency.
The interest rate that has the strongest effect on short-term market rates and is therefore considered the Central Bank’s key rate may change from time to time. Prior to the financial crisis of autumn 2008, the Bank’s key rate was generally considered to be the rate on its collateralised loans to credit institutions, which were in great demand. In the wake of the crisis, however, demand for Central Bank loans has been limited, and credit institutions have increased their deposits with the Bank. As a result, the interest rate on deposits with the Bank has had greater influence on money market rates since 2009. At present, the Bank’s key rate is its seven-day term deposit rate.