6a: Monetary Policy

Question 1

Design of the ECB

Answer 1

Anglo-French model:

• Price stability as one of many objectives such as stabilization of the business cycle, maintenance of high employment, financial stability.
• Political dependence of National Central Bank (NCB): Monetary policy decisions are subject to minister of finance’s approval

German model:

• Single objective: Price stability
• Complete political independence

Question 2

Usage of German Model in ECB

Answer 2

Intellectual revolution: From Keynesianism to Monetarism

• Stagflation in the 1970s showed problems of Keynesian monetary policies led to new economic theories: Monetarists were the first to state governments can only bring down unemployment temporarily and not below the NAIRU. If it tries to do so, it will pay a price namely higher inflation in the future.
• Neo-classical theories of the time were backed by empirical support by a series of studies in the 1980s and 1990s.

Germany’s strategic positioning:

• German monetary authorities insisted on having an ECB that gives an even higher weight to price stability than the Bundesbank did.
• This victory was greatly facilitated by the fact that most central bankers had been converted to monetarism.

Question 3

Institutional Setup

Answer 3

Siehe Übersicht.

Question 4

Price Stability

(Neutrality of Money & Inflation)

Answer 4

Long-run neutrality of money

• change in the quantity of money reflected in a change in the general level of prices
• not induce permanent changes in real variables such as real output or unemployment
• Real income or the level of employment are, in the long term, essentially determined by real factors, such as technology, population growth or the preferences of economic agents.

Inflation – a monetary phenomenon

• In the long run a central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices.
• Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth.

Question 5

ECB - a conservative bank?

Answer 5

• In a nutshell, the ECB appears to be more conservative than the US Federal Reserve.
• There is now consensus among economists that the Fed’s monetary policies during 2001–04 were too expansionary for too long:
• Fueling a boom in the US housing market.
• Contributing to a general consumption boom in the US.
• These booms have come to a spectacular end in 2007.

Question 6

Country Differences in Inflation

Answer 6

Lasting inflation differentials:

• If certain countries show significantly higher inflation rates than others they will lose competitiveness and have to go through painful restructuring.
• Inflation results in an external deficit
• Possible Explanations why this happens in EMU:
  
  • Balassa-Samuelson effect
  • Wrong initial conversion rates
  • Autonomous wage and price pressure
  • Policy flaws

Asymmetric monetary policy effects

• Different inflation rates also determine real interest rate
• A single monetary policy can have different consequences, given the reasons for higher inflation.

Question 7

ECB and Financial Markets

Answer 7

Home Country Control principle: NCBs are responsible for the banks of the respective country.

Host country responsibility: National authorities are responsible for the stability of the banking system in their own country.

Thus:

• NCBs need information on the soundness of the banks operating in their territory so as to detect banking problems.
• A significant part of that information (if at all), however, is held by the supervisory institutions in other countries.
• Experience shows that institutions tend to guard information jealously.

The supervisory system in the Eurozone has failed and has contributed to the banking crisis that erupted in 2007-08.

Banks have profited from this situation, in many ways:

• The lack of effective supervision has allowed banks to expand their balance sheets and to take on excessive risks
• Balance sheets of major European banks experienced explosive development

At the same time, the banking market is highly fragile:

• Fragility based on trust.
• Moral Hazard problem
• Devilish circle of liquidity and solvency crisis.