European Monetary Policy

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European Monetary Policy

• 3.2. The Monetary Transmission Mechanism

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3.2.1. The Quantity Theory

• Describes the effects of monetary policy on
  inflation, i.e., how the growth of the money
  stock affects prices without reference to
  interest rates (Monetarism)
• Does not explain why and how monetary policy
  affects prices
• Plays an important role in the announced strategy
  of the ECB

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Implications drawn by the ECB

• Inflation is ultimately a monetary phenomenon.
  The Governing Council therefore recognised that
  giving money a prominent role in the Eurosystems
  strategy was important. Money constitutes a
  natural, firm and reliable nominal anchor for
  monetary policy aiming at the maintenance of
  price stability. The important role played by
  money in the overall stability oriented strategy
  also emphasises the responsibility of the
  Eurosystem for the monetary impulses to
  inflation, which a central bank can control more
  readily than inflation itself. To signal the
  prominent role it has assigned to money, the
  Governing Council has announced a quantitative
  reference value for monetary growth as one pillar
  of the overall stability oriented strategy.
• ECB Monthly Bulletin, January 1999, p.

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When does the quantity theory apply?

• Historically gold and silver discoveries in 16th
  and 17th century lead to a huge in the money
  supply (composed of gold and silver). This in
  turn led to inflation.
• At present financing of public sector
  expenditures by printing banknotes is the most
  important cause of high inflation in developing
  countries
• IMF stabilisation programmes reduce public
  sector expenditures in order to put a halt to
  monetary financing

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Relationship between M3 and inflation (HICP) in
the Euro area
M3 growth
Inflation
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Reasons for the weak relationship

• M3 is mainly used as store of value, and not as
  means of payment as dictated by the quantity
  theory
• Inflation is determined by aggregate demand
  (which in turn depends on interest rates), by
  wages and by commodity prices
• There is no financing of public sector deficits
  by printing money
• The relation between M3 growth and inflation is
  to be interpreted as a medium run relation (in
  the terminology of O. Blanchard)

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3.2.2. Stages in the transmission of monetary
policy (ECB)

• The process through which monetary policy
  decisions affect the economy, and the price
  level, is known as the transmission mechanism of
  monetary policy.
• The individual links through which monetary
  policy impulses (typically) proceed are known as
  transmission channels.

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3.2.2. Stages in the transmission of monetary
policy (ECB)
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3.2.2. Stages in the transmission of monetary
policy (ECB)

• The (long) chain of cause and effect linking
  monetary policy decisions with the price level
  starts with a change in the official interest
  rates set by the central bank
• Given its monopoly over the creation of base
  money, the central bank can fully determine the
  interest rates on its operations.
• Through this process, the Central Bank can
  influence and steer money market interest rates
  which has impact on interest rates set by
  commercial banks on short term loans and
  deposits.

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3.2.2. Stages in the transmission of monetary
policy (ECB)
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3.2.2. Stages in the transmission of monetary
policy (ECB)
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Stages in transmission of monetary policy
(interest rate pass-through) 1988-98
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3.2.2. Stages in the transmission of monetary
policy (ECB)

• Monetary policy can affect other financial
  variables such as asset prices (e.g. stock market
  prices) and exchange rates.
• Changes in interest rates and financial asset
  prices in turn affect the saving, spending and
  investment decisions of households and firms and
  the supply of credits (Why?)
• leading to a change of demand for goods and
  services relative to domestic supply. When demand
  exceeds supply, c.p. upward pressure on prices is
  likely to result.

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3.2.2. Stages in the transmission of monetary
policy (ECB)

• The exchange rate pass-through three effects of
  exchange rates on domestic prices
• Direct effect through prices of imported goods
• If these imported goods are used as inputs into
  the domestic production process
• The effect of domestic competitiveness
  (appreciation makes domestic goods less
  competitive abroad).

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3.2.2. Stages in the transmission of monetary
policy (ECB)

• Anchoring inflation expectations If a central
  bank enjoys a high degree of credibility in
  pursuing its objective, powerfully influence
  price developments by guiding economic agents
  expectations of future inflation and thereby
  influencing their wage and price setting behavior

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3.2.2. Stages in the transmission of monetary
policy (ECB)
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3.3. Fiscal Policy in the EU

• The Reform of the Stability and Growth Pact

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Stability and Growth Pact

• Origins of the Pact (to caricature a bit)
• French considered ESCB statutes a necessary evil
  to bring Germany into a monetary union
• France wanted a strong countervailing power
• Germany refused a monetary union without some
  economic convergence
• Germany wanted rules to maintain fiscal
  discipline once monetary union achieved

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The Macroeconomic Role of Fiscal Policy. The
Stabilisation Role

• Automatic Fiscal Stabilisers (no govt action
  required).
• A rise in output increases tax revenues and
  decreases government expenditures. This dampens
  the increase in output.
• A fall in output lowers tax revenues and raises
  government expenditures. This increases output.
• Discretionary Fiscal Policy.
• Policy changes in govt. expenditures and/or
  revenues.
• Cyclically Adjusted Budget Deficits (CAB).
• Actual budget deficits minus the automatic
  changes.

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Why Fiscal Rules?

• Historical Background
• In the 1980s, there was a large accumulation of
  government debt in most OECD countries, which was
  unprecedented in peacetime.
• As a consequence, fiscal sustainability became
  the main fiscal policy issue, and major reforms
  of the fiscal policy framework were undertaken in
  nearly all OECD countries.

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The Stability and Growth Pact (SGP)

• Legal Basis
• Article 99 of the EC Treaty - multilateral
  surveillance
• through monitoring of economic policies and the
  publication of Broad Economic Policy Guidelines
• Article 103 of the EC Treaty no bail out
  clause
• Article 104 of the EC Treaty - Excessive Deficit
  Procedure (EDP)
• procedures for establishing existence of, and
  taking effective action against, excessive
  deficits and debt levels.
• Protocol on EDP annexed to the Treaty
• definition of reference values for excessive
  government budget deficit and debt and other
  details.

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The Stability and Growth Pact (SGP)

• Relevant texts
• Council Regulation 1466/97 on the strengthening
  of the surveillance of budgetary positions and
  the surveillance and coordination of economic
  policies the preventive arm
• aims, through regular surveillance, at preventing
  budget deficits going above the 3 reference
  value. Requires the submission of stability and
  convergence programmes.
• imposes a medium-term objective of a government
  budget close to balance or in surplus
• measured in cyclically adjusted terms (see Code
  of Conduct)
• Council Regulation 1467/97 on speeding up and
  clarifying the implementation of the EDP the
  dissuasive arm
• in the event of the 3 reference value being
  breached, requires Member States to take
  immediate corrective action, and, if necessary,
  allows for the imposition of sanctions. Council
  can provide an early warning of an eventual
  deficit.

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Stability and Growth Pact (SGP)

• Art. 104.1 Member States shall avoid excessive
  deficits
• exception UK (shall endeavour to avoid excessive
  deficits)
• Art. 104.2 specifies the meaning of excessive
  deficits. An excessive deficit exists if
• the ratio of the planned or actual government
  deficit to GDP exceeds a reference value
• the ratio of government debt to GDP exceeds a
  reference value

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Stability and Growth Pact

• The reference values are specified in a protocol
  to the Treaty
• 3 for the ratio of the planned or actual
  government deficit to GDP at market prices
• 60 for the ratio of government debt to GDP at
  market prices.
• The concepts are defined statistically in
  Regulation 3605/93 (revised by regulations
  475/2000 and 351/2002)

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Stability and Growth Pact

• Art. 104.3 to 6 concern the procedure for
  identifying situations of excessive deficit
• Art. 104.7 to 11 concern the procedure for
  ensuring the correction of excessive deficits
• Art 104.7 and 8 apply to all EU Member States
• Art 104.9 to 11 apply only to Euro-area Member
  States
• Art 104.12 concerns the abrogation of the EDP
  when the Member State is deemed to have corrected
  its excessive deficit.

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Stability and Growth Pact

• Council Regulation 1466/97
• also known as the preventive arm
• Euro-area MS must submit a pluri-annual
  stability programme updated annually
• the other MS must submit a pluri-annual
  convergence programme updated annually
• the contents are identical
• the programme should lay down how the MS plan to
  respect the norms laid down in the excessive
  deficit procedure

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Stability and Growth Pact

• The programme must
• include the medium-term objective for a budgetary
  position which is close to balance or in surplus
• indicate the adjustment path towards this
  objective.
• The Council will decide whether to approve the
  stability programme or to invite the member state
  to adjust it.

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Stability and Growth Pact

• The Council will also monitor its implementation
  and may issue recommendations in this context.
• The Council may issue an early warning to a
  Member State before an excessive deficit occurs.
• Article 104.2 of the Treaty allows the ratio of
  the planned or actual government deficit to gross
  domestic product to exceed the reference value
  only if this situation is exceptional and
  temporary

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Stability and Growth Pact

• Council Regulation (EC) 1467/97 defines what is
  to be understood by exceptional and temporary.
• In particular, it states that an excess over
  the reference value resulting from a severe
  economic downturn will be considered exceptional
  only if there is an annual fall of real GDP of at
  least 2.

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Stability and Growth Pact

• A smaller decline can only be considered
  exceptional by the Council,
• on the initiative of the Member State concerned,
• when there is supporting evidence on the
  abruptness of the downturn or on the accumulated
  loss of output relative to past trends.
• Annual falls of less than 0.75 will not be
  considered as severe

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Stability and Growth Pact

• The procedure laid down in Article 104 of the EC
  Treaty to be followed for establishing an
  excessive deficit is further specified in
  Regulation (EC) 1467/97 which lays down
• that decisions are taken by (a majority of two
  thirds of the votes of) the Council, excluding
  (the votes of) the representative of the Member
  State concerned, and acting on a recommendation
  from the Commission.
• the deadlines that are to be observed
• the rules for monitoring and assessment of the
  corrective actions taken
• and the eventual application of sanctions if
  corrective action is not taken or deemed
  unsatisfactory
• sanctions are applied only to Euro-area members
• in the event of persistent excessive deficits

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Stability and Growth Pact

• Sanctions
• in the first year of sanctions, the MS concerned
  must pay a non-interest bearing deposit equal to
• fixed component 0.2 of GDP, plus
• variable component 10 of difference between
  deficit and the 3 reference value
• a ceiling of 0.5 of GDP is set.
• in subsequent years only the variable component
  is paid

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The Stability and Growth Pact in Action

• The SGP entered into force with the start of
  monetary union
• 1 July 1998 for Regulation 1466
• 1 January 1999 for Regulation 1467
• In the lead up to monetary union
• there was a great effort made towards fiscal
  consolidation
• in order to qualify for membership in the
  monetary union
• Since the start of monetary union
• there has been a steady relaxation in the effort
• so that now we appear to be back in 1991 re
  fiscal consolidation

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The Stability and Growth Pact in Action

• Portugal
• 30 January 2002 Commission proposes that an
  early warning be issued to Portugal (and
  Germany) under Regulation 1467/97.
• 12 February 2002 Council decides not to do so
  Portugal profits from heavy pressure exerted by
  Germany.
• 16 October 2002 Commission issues an opinion
  that an excessive government deficit exists in
  Portugal. Art. 104 (5)
• 5 November 2002 Council declares that an
  excessive deficit exists in Portugal and
  recommends action. Art. 104 (6) and (7)
• Portugal acts to remove the excessive deficit
• Excessive deficit procedure against Portugal was
  abrogated this spring (2004)

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The Stability and Growth Pact in Action

• Germany
• 30 January 2002 Commission proposes that an
  early warning be issued to Germany (and
  Portugal)
• 12 February 2002 Council decides not to do so
  under heavy pressure from Germany (pre-election
  period).
• 8 January 2003 Commission issues an opinion that
  an excessive government deficit exists in Germany
  Art. 104 (5)
• 21 January 2003 Council decides that an
  excessive deficit exists in Germany and
  recommends action Art. 104 (6) and (7)
• 18 November 2003 Commission issues an opinion
  that Germany has not acted on the recommendation
  and proposes legally binding measures Art. 104
  (8) and (9)
• 25 November 2003 Commission recommendations do
  not obtain the required qualified majority.
  Council proceeds further (see below) and adopts a
  set of conclusions put forward by the Italian
  Presidency.

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The Stability and Growth Pact in Action

• France
• 21 January 2003 France receives an early
  warning from the Council
• 7 May 2003 Commission issues an opinion that an
  excessive government deficit exists in France
  Art. 104 (5)
• 3 June 2003 Council decides that an excessive
  deficit exists in France and recommends action
  Art. 104 (6) and (7)
• 21 October 2003 Commission issues an opinion
  that France has not acted on the recommendation
  and proposes legally binding measures. Art 104
  (8) and (9)
• 25 November 2003 Commission recommendations do
  not obtain the required qualified majority.
  Council proceeds further (see below) and adopts a
  set of conclusions put forward by the Italian
  Presidency.

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The Stability and Growth Pact in Action

• Three elements in the Council proceedings on 25
  Nov. 2003
• 1. It did not accept the Commissions
  Recommendations under Article 104 (8) and 104
  (9) no qualified majority in favour.
• 2. It used the voting procedure of Article 104
  (9) to vote in a new set of conclusions.
• 3. These conclusions were in the nature of a new
  recommendation.
• The Commission sued the Council before the ECJ
  which concluded (in substance) on 13 July 2004
  that
• The lack of a qualified majority effectively held
  the excessive deficit procedure in abeyance
  till the Commission proposed a new recommendation
• The Council acted illegally in proposing a new
  recommendation (a prerogative of the Commission)

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Reforming the Stability and Growth Pact

• Relevant texts
• Strengthening Economic Governance and Clarifying
  the Implementation of the Stability and Growth
  Pact, Communication of the Commission of 3
  September 2004, COM(2004)581 final.
• Improving the Implementation of the Stability
  and Growth Pact, Council report agreed by the
  ECOFIN Ministers at their extraordinary meeting
  of 20 March, and endorsed by the European Council
  of 22/23 March 2005.
• Proposal for a Council Regulation amending
  Regulation (EC) No 1466/97 on the strengthening
  of the surveillance of budgetary positions and
  the surveillance and coordination of economic
  policies, (presented by the Commission),
  COM(2005) 154 final, Brussels, 20.4.2005
• Proposal for a Council Regulation amending
  Regulation (EC) No 1467/97 on speeding up and
  clarifying the implementation of the excessive
  deficit procedure (presented by the Commission),
  COM(2005) 155 final, Brussels, 20.4.2005.