Financial Frictions And Business Cycles In Middle-Income Countries

Given recent developments in Iceland, this paper evaluates its real exchange rate disequilibrium. It discusses three approaches to estimating the equilibrium values and suggests that the adjustment needed to bring the real exchange rate in line with fundamentals is in the range of 15-25 percent, although timing and manner of this adjustment is unclear. This paper addresses this question by using methodologies developed by the IMF Research Department (IMF, 2006) for evaluating exchange rate disequilibria. These methodologies comprise three analytical approaches that tackle the issue from somewhat different angles.