The three case questions are:

1) Do you think a country the size of Iceland or New Zealand is more or less sensitive to the potential impacts of global capital movements?

2)Many countries have used interest rate increases to protect their countries for many years. What are the pros and cons of using this strategy?

3) In the case of Iceland, the country was able to sustain a large current account deficit for several years, and at the same time have ever-rising interest rates and stronger currency. Then one day, it all changed. How does that happen?

PART 2 CASE 1 ICELAND 2006-A SMALL COUNTRY IN A GLOBAL CAPITAL MARKET More than almost anything, Icelanders like a soak in hot wa Reykjavik has more themal spas per head than any other city in the world. But lately, the North Atlantic nation has been feel- Exhibit A Iceland's Interest Rates Continue to Rise more heat than it bargained for. On Febraary 1st Fitch, a ing rating ag negative from stable, drawing attention to a deficit that ballooned to 15% of GDP m 2005 and fast-raising foreign debt. With only 300,000 people and an economy one thind the size of Luxembouag's, Iceland's trotubles may sound like the fabled headine, "Small earthquake: not many dead." But dire wamings of contagion have flouerished out of all pro- ency, cut its outlook on Icelandic sovereign debt to Lending Rate current-account Money Market rtion to the country's sire "Storm in a Hot Tub," The Economist March 30, 2006 The last one or two years had been something of a shock to the Icelandic people. Long used to being ignored Souvce in the world, Iceland's economic situation and its interest International Financial Statistics, monthly rates--some of the highest in the world recently-had suddenly garnered much international attention. Now, in behind the carry-trade made famous in Ja the spring of 2006, Iceland's central bank and governmen landic money market interest rates very attractive. Capital tal monetary authorities were wondering whether they from foreign investors, American and European, flowed were seeing the dark underside of globalization and eco into t nomic growth. Is this what it felt like to be a small country accounts of all kinds to take advantage of these higher in a global market? oe i Monetary Fund by lceland the big four Icelandic banks and money market money market rates But the carry-trade depends on exchange rates as well as interest rates. A foreign investor exchanging U.S. dol lars or euros for Icelandic krona, and then investing in the higher yielding money market rates in Iceland, must feel relatively confident that the krona will not fall in value versus their currency by the time they need to bring the money back home. And they did. The krona had actually strengthened consistently against both the dollar and the OVERHEATING Iceland's economy had been growing at record rates in re Gross domestic product had grown at just over 8 percent in 2004, 6 percent in 2005, and was expected to be still above 4 percent by the end of the current year, cent years. While the average unemployment rate of the major economic powers was roughly 6 percent, Iceland's over euro in 2004 and 2005, as illustrated in Exhibit B. By the heating economy had only 3 percent unemployment. But end of 2005 the krona was stronger against both the dollar accompanying rapid economic growth in a small economy, and the euro than it had been since 2000 as happens frequently in economic history, inflation raises A les desirable result of this process is that interest its ugly head. And the requisite prescription for such an rates rise for everyone, including domestic Icelandic com- ailment by monetary authorities is also well known: slow panies wishing to borrow money. Monetary policies like ing money supply growth to try and control inflationary these have been known to bring domestic business to a orces. The result is always the rates, as illustrated in Exhibit A. same-increasing interest standstill-which is in many ways the intent-to slow siness forces driving inflation. But Iceland and many l These higher interest rates had a number of different landic companies were more and more global, and when impacts. First, Iceland was considered very stable and low borrowing rates ("lending rates") continued to rise in 2004 risk in the international marketplace. It-the Icelandic and 2005, they started borrowing abroad. Any company dan investment grade credit rating. So that could raise debt outside of Iceland, in Europe in euros foreign investors, particularly the money market investors for example, did 119