Term Paper: Monetary Policy of the European Central Bank

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Monetary Policy of the ECB

MONETARY POLICY of the EUROPEAN CENTRAL BANK

ITEM NO.

ITEM TITLE PAGE NO.

Price Stability

Role of Monetary Policy

ECB Basic

Current Best Practice: Predictability

Interest Rates

Optimal Monetary Policy Rule

ECB Credibility

Legislative Powers of the ECB

Interest Rate 'Smoothing' Practice of ECB

Communication of Monetary Policy Critically Important

OECD's Recommendations for the ECB (January, 2007)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

FIGURE NO.

FIGURE TITLE

Figure 1 Primary Transmission Channels of Monetary Policy Decisions

Figure 2 the Decision-Making Bodies of the ECB

Figure 3 Average number of trades per minutes, on press conference days compared with Thursdays without Governing Council Meetings 1999- 2006

Figure 4 Decomposition of changes in the money market yield curve on Governing Council Meeting Days

Figure 5 Market reaction of euro area interest rates to speeches and interviews by Governing Council members 1999-2004

Figure 6 Central Bank Balance Sheet Structure

Figure 7 Contributions to the Banking System's Liquidity

Figure 8 Volume of the Main and Longer-Term Refinancing Operations

Figure 9 Require Reserves and Autonomous Liquidity Factors

Figure 10 Estimates of responses of real GDP and consumer prices to a one- percentage point increase in the policy-controlled interest rate in the euro area

MONETARY POLICY of the EUROPEAN CENTRAL BANK

ABSTRACT

The monetary policy of the European Central Bank (ECB) is one that is optimally transparent and clearly communicated to the public so as to avoid any misunderstandings and as well to avoid any shock effect to the economy due to shifting changes in the interest rates. It is critically necessary that the monetary policy of the central bank be one that is characterized by stability, credibility, and predictability. In fact, the word "boring" has been used to describe the activities of the central bank in that the central banking function is one of an extremely uneventful nature in the optimal sense. The primary objective of the ECB monetary policy is "to maintain price stability" which is set out in the Treaty establishing the European Community. The operation framework of the ECB follows the guiding principles of: (1) operational efficiency; (2) equal treatment and harmonization; (3) decentralized implementation; and (4) simplicity, transparency, continuity, safety and cost efficiency." (ECB, 2007)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

EXECUTIVE SUMMARY

Primary among the concerns of monetary authorities is stability in the financial sector and history speaks clearly of monetary instability brought on by the financial sector. The Great Depression is one example of this principle. When depositors lack trust in the bank withdrawals of money may result in a 'run on a bank', which results in bank's inability to produce all the monies being called in by depositors. In the case where several various banks simultaneously bankrupt recession of a serious nature is likely. Fortunately, the central bank's provision of deposit insurance and liquidity support work toward the prevention of such occurrences. The European Central Bank is stated to play a role relating to responsibility for ensuring financial stability in the majority of EU countries. (Goodhart and Schoenmaker, 1995) the work of Eijffinger (2001) entitled: "Evaluation of the Economic Situation in Europe - 2nd Quarter 2001 (May 2001) for the European Parliament: Should the European Central Bank Ben Entrusted with Banking Supervision in Europe?" states: "The ECB is not entrusted with any direct responsibility related to prudential supervision of credit institution and the stability of the financial system. These functions are in the realm of the competent national authorities. (Eijffinger, 2001) in a study presented at the Royal economic Society's Annual Conference the question is asked as to why the ECB has "such a poor reputation for transparency, when money market dealers have no problem in understanding what is going on - and why the Bundesbank was regarded as a model of successful central banking when it revealed so little of its thinking? In recent years, we have seen an emerging consensus that central banks should be not just independent of governments, but also 'transparent' and open in their conduct of policy." (Why the European Central Bank's Monetary Policy Seems Less Transparent, nd) as a matter of fact, Central Banking should be quite dull according to Bank of England Governor Mervyn King who states specifically of Central Banking that is should be extremely boring. First it is stated that criticism is widely spread of the ECB relating to the sending of 'confused messages' and additionally stated is a "...paradox. When it comes to transparency, the acid test is whether or not people can anticipate on average what the central bank is going to do." (Why the European Central Bank's Monetary Policy Seems Less Transparent, nd)

MONETARY POLICY of the EUROPEAN CENTRAL BANK

INTRODUCTION

According to the European Central Bank the objective of monetary policy is "to maintain price stability" which is set out in the Treaty establishing the European Community. Stated is: "Without prejudice to the objective of price stability" the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community." (ECB, 2007) This is to include a "high level of employment" as well as "sustainable and non-inflationary growth." (ECB, 2007) the provisions of the Treaty illustrate the consensus that: (1) the benefits of price stability are of a substantial nature; and (2) the natural role of the monetary policy in the economy is to maintain price stability. (ECB, 2007; paraphrased)

LITERATURE REVIEW

I. PRICE STABILITY

The definition of price stability has been assigned by the ECB Governing Council as follows: "Price stability is defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro are of below 2%." (ECB, 2007) the benefits of price stability are listed as: (1) Makes the monetary policy more transparent; (2) Provides a clear and measurable yardstick against which the European citizens can hold the ECB accountable; and (3) Provides guidance to the public for forming expectations of future price developments. (ECB, 2007) the reasons that the ECB aims for 2% year-to-year increases are stated to be because "it also underlines the ECB's commitment to: (1) Provide an adequate margin to avoid the risks of deflation. Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment, monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation; (2) Take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP; and (3) Provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation." (ECB, 2007)

II. ROLE of MONETARY POLICY

The ECB is "the sole issuer of banknotes and bank reserves..." meaning it is the "monopoly supplier of the monetary base." (ECB, 2007) Because of the monopoly of the ECB, the ECB is able to make the conditions at which the banks are enabled to borrow from the central bank and as well is able to influence the conditions under which trade between banks take place in the money market. Stated is: "Ultimately the change will influence developments in economic variables such as output or prices. This process - also known as the monetary policy 'transmission mechanism' - is highly complex. While its broad features are understood, there is no consensus on its detailed functioning." (ECB, 2007) Inflation is "monetary phenomenon." High monetary growth is generally associated with long periods of high inflation. Since the ECB is the monopoly supplier of the monetary base, which consists of:

1) Currency (banknotes and coins);

2) the reserves held by counterparties with the Eurosystem; and 3) Recourse by credit institutions to the Eurosystem's deposit facility." (ECB, 2007)

The central bank is able to signal its monetary policy stance to the money market through changing the conditions that the central bank is willing to enter into transactions with institutions of credit. Furthermore, the central bank as well aims to make sure of the money market's proper functioning and assist credit unions in meeting needs in liquidity through provision of regular financing to credit institutions and allowing these institutions to deal with "end-of-day balances and to cushion transitory liquidity fluctuations." (ECB, 2007) the operational framework of the Eurosystem is stated to be "based on the principles laid down in the Treaty on the European Union specifically Article 105 of the treaty which states that in achieving its objectives the Eurosystem "...shall act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources..." (ECB, 2007) the operational framework also followed several guiding principles which are those of: (1) Operational efficiency; (2) Equal treatment and harmonization;… [END OF PREVIEW]

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