Chapter%209:%20Monetary%20Policy%20in%20the%20Eurozone

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Chapter 9Monetary Policy in the Eurozone
De Grauwe Economics of Monetary Union
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Monetary policy when asymmetric shocks occur

• In an optimum currency area few asymmetric shocks
  occur
• ECB has a relatively easy time to stabilize
  shocks
• There are few conflicts between member-states and
  the ECB

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The ECB and asymmetric shockspolicy paralysis
France
Germany
PF
SG
PG
SF
DG
DF
YG
YF
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The ECB and symmetric shocks stabilisation is
possible
France
Germany
PF
PG
YG
YF
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Have asymmetric shocks been important in the
operation of the Eurosystem since 1999?
Figure 9.4 Growth of real GDP in the Eurozone
2003
2005
Wide range of experiences
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Figure 9.5 Inflation in the Eurozone
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Output gap is a good measures of the business
cycle position of countries

• Output growth differences also reflect permanent
  asymmetric shocks (e.g. productivity growth
  differences
• A measure of temporary shocks (business cycle) is
  provided by the output gap
• We observe large differences
• These differences in inflation and output gap
  experiences lead to different desired interest
  rates of different countries
• We can measure these different desired interest
  rates using the Taylor rule

Output gaps in the Eurozone in 2005 ()
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• Wide range of desired interest rates in 2003
  (Germany desired interest rate of 1.22, Ireland
  desired interest rate of 7.9
• ECB computes average desired interest rate
• Many countries are likely to be less than
  enthusiastic about the interest rate decisions of
  the ECB

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Asymmetric shocks and housing prices

• Large inflation differences within Eurozone
• Combined with the same nominal interest rate in
  the Eurozone
• Create large differences in real interest rates

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Large differences in real interest rates in
Eurozone
Figure B17.1 Average real interest rates in
Eurozone countries (19972005)
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Create large differences in house price inflation
Figure B17.2 House price indices ( change over
19972006)
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Figure B17.3 Real interest rate and house prices
( change) 19982005
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The Monetary Policy Strategy of the ECB a
description

• Monetary Policy Strategy (MPS) of ECB consists of
  two parts
• A definition of the objectives
• The instruments to achieve these objectives

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The objectives

• The Governing Council of the ECB has adopted the
  following definition
• price stability shall be defined as a
  year-on-year increase in the Harmonised Index of
  Consumer Prices (HICP) for the euro area of below
  2
• Thus target range of inflation is 0 to 2
• However, recent clarification inflation
  should remain below but close to 2
• Medium run objective
• The ECB does not define what the medium run is
• No mention of other objectives

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The instruments

• Two pillars
• First pillar Money stock is reference value
• M3 reference value 4.5
• implicit model
• m v p y
• ?m ?v ?p ?y
• ?m ?p ?yf - ?vf
• Same procedure of Bundesbank

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The second pillar

• Second pillar
• Other reference values
• Wages
• Energy prices
• Exchange rate
• Yield curve
• Possibly other variables

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The Monetary Policy Strategy of the ECB an
evaluation

• The selection of the target
• Is inflation target of at most 2 too low?
• Two-pillar strategy

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Selection of the target

• In interpreting its mandate ECB has been
  influenced by the theory of flexible inflation
  targeting as developed by Svensson (1996, 2000)
• The central claim made by this theory is that by
  stabilizing the price level, the central bank
  also stabilizes the output level
• In this view there is no need to target output
  explicitly
• Not consistent with mandate set out in Maastricht
  Treaty

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Shocks in aggregate demand and supply
Demand shock
Supply shock
AS
AS
AS
Price level
Price level
AD
AD
AD
Normal Output
Output
Normal Output
Output
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• When demand shocks occur, inflation targeting
  stabilizes prices and output
• Not so when supply shocks occur in this case
  there is trade-off between output and inflation
  stabilization
• ECB has made clear that when such a trade-off
  occur it will choose for inflation stabilization
• Even then gradualism can be applied

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Is the inflation target of at most 2 too
low?Answer Yes

• Rapid technological progress changes the
  conventional measures of inflation
• The true inflation rate is overestimated by 0.5
  to 1.5 a year (quality bias)
• Some inflation is good for the economy
• It works as a lubricant and allows for more
  flexible adjustments in real wages
• Argument is based on money illusion

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• 3. Large differences in inflation together with
  low target pushes inflation in some countries
  close to zero, possibly below zero

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Conclusion on objectives

• 2 maximum inflation rate is too low
• The idea of setting a maximum rate is not a good
  one
• The economy is subjected to shocks
• A precise control of the rate of inflation is
  very difficult
• Setting a maximum rate creates an issue of
  credibility

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Inflation in Eurozone
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A different target is necessary

• ECB should redefine its target to be a number
  between 2 to 3
• Then it should allow some flexibility around this
  new target in a symmetric way
• This is the approach taken by the Bank of England
  (target 2.5, with some leeway above and below
  it)

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Excessive reliance on the money stock?

• Is money targeting passé?
• Measuring the money stock in a world of financial
  innovation
• Volatility of velocity in new monetary regime
• Money stock often gives wrong signals especially
  in low inflation environment (see next slide)
• Since May 2003 the ECB has reduced the prominence
  it gives to the money stock
• Monetary analysis remains important

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Inflation targeting a model for the ECB?
Instrument Intermediate target
Ultimate target
MS-targeting
Interest rate
Money stock
Inflation
Inflation forecast
Inflation
Inflation-targeting
Interest rate

• Inflation targeting is superior to money stock
  targeting (see Svensson (1998))
• The reason is that with inflation targeting the
  central bank uses information of all the
  variables (including the money stock) that will
  affect future inflation
• The inflation forecast is then the best possible
  intermediate target

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The instruments of monetary policy in Euroland

• Three types of instruments
• Open market operations
• Standing facilities (credit lines)
• Minimum reserve

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1. Open market operations

• Buying and selling of securities with the aim of
  increasing or reducing money market liquidity
• ECB uses system of tenders, called main
  refinancing operations
• Governing Council sets the interest rate that
  will be applied in the main refinancing
  operations

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ECB Financing rate
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• The ECB then announces a tender procedure
• This can be a fixed rate or a variable rate
  tender
• If a fixed rate tender, the interest rate chosen
  by the Governing Council is fixed at which
  financial institutions can make bids
• These bids are collected by the NCBs and
  centralized by the ECB
• The ECB decides about the total amount to be
  allotted, and distributes this to the bidding
  parties pro rata of the size of the bids
• ECB now only uses variable rate tenders

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Table 8.3 Hypothetical example of variable rate
tender (million euros)
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• Assume that the minimum bid rate set by the
  Governing Council is 3
• Three cases
• First, ECB decides to allot 80 million Euros,
  then all bids of 3.02 and more are satisfied
• The minimum bid rate does not bind
• Second, ECB decides to allot 150 million.
• The minimum bid rate is binding. All bids of 3
  and more are accepted (130)
• The allotted amount of liquidity (150) is not
  exhausted

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• Third, ECB decides to allot 120
• There is unsatisfied bidding at the minimum bid
  rate of 3
• All bids at 3.01 and more are accepted, and each
  bank is allotted 1/3 (5/15) of the amounts they
  bid at the minimum rate

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In sum

• Open market operations are the main tools for the
  ECB to affect monetary conditions
• By increasing or reducing the interest rate on
  its main financing operations it affects the
  market interest rates
• In addition, by changing the size of the
  allotments it affects the amount of liquidity
  directly

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2. Standing facilities

• These facilities aim to provide and absorb
  overnight liquidity
• Banks can use the marginal lending facility to
  obtain overnight liquidity from the NCBs
• The Governing Council fixes the marginal lending
  rate (1 above the interest rate used in the main
  financing facility)
• No borrowing limit, provided collateral
• The marginal lending rate acts as a ceiling for
  the overnight market interest rate

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• Banks can use the deposit facility to make
  overnight deposits
• The Governing Council fixes the interest rate on
  the deposit facility (1 below the interest rate
  used in the main financing facility)
• This interest rate acts as a floor for the
  overnight market interest rate

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3. Minimum reserves

• By manipulating reserve requirements the ECB can
  affect money market conditions
• ECB remunerates the minimum reserves
• The ECB uses the minimum reserve requirements as
  an instrument to smooth short term interest rates

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Conclusion

• ECB has quite a large range of instruments at its
  disposal
• As money markets in Euroland integrate further,
  the interventions in the money markets will
  increasingly be centralized