MONETARY POLICY
Valanta Milliou
cmilliou@aueb.gr
http://www.aueb.gr/users/milliou/teaching.html
Definitions
Monetary policy is the process by which the government, central bank,
or monetary authority of a country controls (i) the supply of money,(ii)
availability of money, and (iii) cost of money or interest rate, in order to
attain a set of objectives oriented towards the growth and stability of the
economy.
Monetary Union entails the surrender of national sovereignty over
monetary policy in favor of a single currency adopted across a wider
region.
→
It implies both costs and benefits to its members: Loss of control over
national monetary policy in return for the potential benefit that accrues
from promoting trade and investment by eliminating exchange rate
fluctuation and uncertainty.
European Monetary Union (EMU)
On 1 January 1999, 11 member-states of the EU embarked upon a
Monetary Union and soon after surrendered their own national
currencies in favor of a single currency.
Currently, 15 member-states of the EU participate in the EMU.
The United Kingdom, Denmark and Sweden have not accepted to
participate in the EMU.
The 10 new countries that acceded to the EU in 2004 all intend to join
the EMU in the next ten years (Cyprus, Malta and Slovenia already
participate). Similarly, those countries who are currently negotiating for
entry will also take the euro as their currency in the years following their
accession.
Objective of EU Monetary Policy
To maintain price stability is the primary objective of the EU monetary
policy.
This is laid down in the Treaty establishing the EC, Article 105(1):
"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".
Objective of the EU Monetary Policy
The Treaty establishes a clear hierarchy of objectives for the Monetary
Policy:
- It assigns overriding importance to price stability.
- It makes clear that ensuring price stability is the most important
contribution that monetary policy can make to achieve the objectives of
the EC (favourable economic environment and high level of
employment).
The Treaty provisions reflect the broad consensus that the benefits of
price stability are substantial.
Benefits of Price Stability
The objective of price stability refers to the general level of prices in the
economy. It implies avoiding both prolonged inflation and deflation.
Price
stability
contributes
to
achieving the EU’s objectives by:
- Improving the transparency of the price mechanism. Under price
stability people can recognise changes in relative prices (i.e. prices
between different goods), without being confused by changes in the
overall price level. This allows them to make well-informed consumption
and investment decisions and to allocate resources more efficiently;
- Reducing inflation risk premia in interest rates (i.e. compensation
creditors ask for the risks associated with holding nominal assets). This
reduces real interest rates and increases incentives to invest;
Benefits of Price Stability
- Avoiding unproductive activities to hedge against the negative impact
of inflation or deflation;
- Reducing distortions of inflation or deflation, which can exacerbate the
distortionary impact on economic behaviour of tax and social security
systems.
- Preventing an arbitrary redistribution of wealth and income as a result
of unexpected inflation or deflation.
The European Central Bank (ECB) has defined price stability as "a yearon-year increase in the Harmonised Index of Consumer Prices (HICP)
for the euro area of below 2%. Price stability is to be maintained over the
medium term".
History Review
1979: The European Monetary System (EMS) and The Exchange Rate
Mechanism (ERM)
1989: “Delors Report” on Economic and Monetary Union
1992: Maastricht Treaty
The Treaty established a timetable according to which the EMU would
be achieved.
It also established the convergence criteria for participation in the EMU.
History Review
Timetable:
Stage 1 (began in July 1990): Elimination of exchange controls and
most restrictions on capital movement.
Stage 2 (began in July 1994): Set up of the European Monetary Institute
(EMI) that monitors and co-ordinates monetary policies of memberstates (create closer policy cooperation and devise multi-annual
programs to reduce inflation and budget deficits)
Stage 3: Irrevocable fixing of exchange rates among countries which
meet convergence criteria and replacement of their national currencies
by the EU currency; transformation of EMI to fully independent
European Central Bank (ECB)
History Review
Convergence criteria:
1. Price Stability: An average inflation rate not exceeding by more than
1.5% that of the three best-performing member-states.
2. Interest Rate Convergence: An average long-term interest rate not
exceeding by more than 2% that of the three best performing memberstates.
3. Budgetary Discipline: A budget deficit of less than 3% of GDP and a
public debt ratio not exceeding 60% of GDP.
4. Currency Stability: An exchange rate maintained within the normal
bands of the ERM for at least two years with no devaluations.
History Review
1994: Start of Stage 2; European Monetary Institute set up in Frankfurt.
1998: Decision by European Council on who meets convergence
criteria: 11 countries in starting group.
1999: Start of Stage 3; ECB takes over monetary policy from national
central banks;
2002: Introduction of Euro coins and banknotes.
The Eurosystem
With a single currency, there can only be one interest rate and one
exchange rate.
→ Thus, one monetary policy.
This police is implemented by the Eurosystem.
The Eurosystem consists of the ECB and the National Central Banks
(NCBs) of the participating countries to the EMU.
The ECB
The ECB is run by an Executive Board.
The Executive Board has 6 members, appointed by the heads of state or
governments of the countries that participate in the EMU.
An important characteristic is that its members are not representing any
country: they are appointed as individuals.
The Governing Council is the key authority deciding on the monetary
policy.
The Governing Council is composed by the Executive Board and the
governors of the NCBs of the EMU.
Its decisions are taken by majority voting, with each member holding one
vote.
Instruments of the Eurosystem
Like most central banks, the main policy instrument of the Eurosystem is
the short-term interest rate.
The reason is that short-term (less than 24h) assets are very close to
cash. Since central banks have a monopoly on the supply of cash, they
can control the short-terms interest rate.
Long-term interest rate cannot be controlled with precision since longterm assets can be provided by both the public and the private sector.
More specifically, the Eurosystem focuses on the overnight EONIA
(European Over Night Index Average), a weighted average of overnight
lending transactions in the euro area’s interbank market.
Instruments of the Eurosystem
Control over EONIA is achieved in two ways:
-
The Eurosystem creates a ceiling and a floor for EONIA by
maintaining open lending and deposit facilities at pre-announced
interest rates.
-
The Eurosystem contact, usually weekly, auctions at a rate that it
chooses. These auctions are the means by which the ECB provides
liquidity to the banking system and the chosen interest rate serves
as a precise guide for EONIA.
Independence and Accountability
Current wisdom is that the Eurosystem must be free to pursue price
stability without outside interference: independence.
However, monetary policy affects citizens in the EMU in a number of
ways: the interest rate directly impacts on the cost of borrowing and the
returns from saving; the exchange rate affects the competitiveness of
firms and the purchasing power of citizens.
This means that by granting independence to the Eurosystem, the
citizens delegate a very important task to a group of unelected
individuals that are appointed.
In a democratic society, delegation to unelected officials needs to be
counterbalanced by democratic accountability.