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Björn Rúnar Guðmundsson

Financialisation in Iceland should be seen as an evolving process driven by a mixture of global and domestic forces. Responding to fundamental issues underlying macroeconomic imbalances, the authorities introduced policies that proved particularly supportive of financial expansion at a time when cross-border capital movements were rapidly on the rise. Consequently, the rise in financial activity has had profound effects on income distribution and corporate and household behaviour. Following the 2008 financial meltdown, which was triggered by excessive growth of the financial sector, financialisation in Iceland has reversed to a degree, allowing for a shift away from financial-led towards increasingly export-led growth.

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Hamid Raza, Bjorn Runar Gudmundsson, Gylfi Zoega and Mikael Randrup Byrialsen

This paper attempts to explain the role of capital inflows in creating economic booms and busts in a small open economy with sovereign currency. We develop a stock–flow consistent (SFC) model for a small open economy while relying on the experience of the Icelandic crisis. We demonstrate the destabilising effects of capital inflows on the economy by allowing for a sudden stop, and also discuss the role of capital controls as a policy response in the event of a crisis due to sudden stops. Finally, we discuss the policy implications of our results in order to tackle the destabilising effects associated with financial flows in a small economy.

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Hamid Raza, Mikael Randrup Byrialsen, Bjorn Runar Gudmundsson and Gylfi Zoega

The aim of this chapter is to understand the international dimension of the crisis in small open economies, which experienced persistent current account deficits before the global financial crisis. We develop a theoretical framework to explain the role of capital inflows in creating economic booms in a small open economy with sovereign currency. We demonstrate the destabilizing effects of capital inflows on the economy. We conclude that large speculative inflows generate debt-led booms, which are not sustainable in the long run. The episode of boom is followed by a bust, which is usually stronger in magnitude than the preceding boom. In particular, sovereign regimes are easily destabilized due to currency risk premiums and large trade balance effects. However, they also have the potential to adjust more rapidly owing to exchange rate flexibility, capital control and autonomous restructuring of the financial sector