Chapter 9: Monetary Policy in the Eurozone

1
Chapter 9Monetary Policy in the Eurozone
De Grauwe Economics of Monetary Union
2
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

3
The ECB and asymmetric shockspolicy paralysis
France
Germany
PF
SG
PG
SF
DG
DF
YG
YF
4
The ECB and symmetric shocks stabilisation is
possible
France
Germany
PF
PG
YG
YF
5
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
6
Figure 9.5 Inflation in the Eurozone
7
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 ()
8

• 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

9
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

10
Large differences in real interest rates in
Eurozone
Figure B17.1 Average real interest rates in
Eurozone countries (19972005)
11
Create large differences in house price inflation
Figure B17.2 House price indices ( change over
19972006)
12
Figure B17.3 Real interest rate and house prices
( change) 19982005
13
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

14
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

15
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

16
The second pillar

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

17
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

18
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

19
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
20

• 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

21
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

22

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

23
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

24
Inflation in Eurozone
25
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)

26
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

27
(No Transcript)
28
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

29
The instruments of monetary policy in Euroland

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

30
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

31
ECB Financing rate
32

• 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

33
Table 8.3 Hypothetical example of variable rate
tender (million euros)
34

• 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

35

• 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

36
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

37
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

38

• 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

39
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

40
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