The Framework of the ECB and Euro System
Describe about the Evaluation of The Monetary Policy for Stabilizing The Euro Currency.
The European central bank is a part of the euro system and is responsible for maintain and framing and implementing the euro system monetary and economic policy. The European central bank has the responsibility of area comprising of twelve various countries having different economic and cultural background. The main and primary objective of ECB is to maintain the price stability so that the purchasing power of the single currency is preserved. The mission of the central bank of Europe is to safeguard the value of euro and maintaining the price stability and thus serving the people of Europe (Oldani 2012). The ECB contributes to the banking system in terms of its soundness and safety. Specific tasks are carried out by the central bank in various areas such as macroprudential policy, bank notes, financial stability and banking supervision including the international cooperation. The bank is primarily held accountable for the representation of the European citizens. As such, its primary responsibility is the financial welfare of the European citizens in the country . Therefore, it is necessary that the transparent and the honest financial policies to prevent any discrepancy and threats that can harm the financial condition of the business entity.
The framework of the ECB has faced substantial changes due to the transfer of the monitory policy at the community level (Belke and Volz 2015).
The European central bank works with all European Union countries national banks. The cooperation between the central banks leads to the creation of the Euro system. It comprises of the three governing bodies and this includes Governing council, General council and the Executive board (Albu et al. 2014). The role of the Governing council is to define the monetary policy of Euro zone and is responsible for fixing the interest rate that is the lending rate of the commercial banks from the European Central bank. The General council contributes to the coordination of work, advise and prepare the new countries in joining the euro (Alessi et al. 2014). The executive board is responsible for implementing the monetary policies and it has power, which is exercised due to the delegation by the Government council. The day to day operations is managed by the executive board and is responsible for preparing the meeting of the Government council (Cassola and Koulischer 2014).
Objectives of the Euro System
The strategies followed by ECB in maintain the price stability comes from the monetary policy and it is based on the quantitative definition of the same. The policy is then channeled through the transmission mechanism to the real economy (Allard et al. 2013). The monitory policy intentions and the interest rates are steered through a set of procedures and instruments such as standing facilities, open market operations, deposit facilities, and maintaining minimum reserve requirement (Aysan et al. 2014). The bank has conducted the monetary policy using the standards measures from the very beginning when it came into existence until the time of global crisis. On the other hand, the non-standard measures used by the ECB include program related to securities market, outright monetary transactions and the program of purchasing assets (Bauer and Neely 2014). However, such non-standard measures faced criticism along with the praise that it received. The bank has the authority of producing the euro banknotes. It is also responsible for managing the foreign currencies reserves of Eurozones and also balances the exchange rates by intervening in the selling and buying of the currencies so as to stabilize the home currency (Allard et al. 2013).
The European Union is a common economic and monetary union and the responsibility of the monetary policy with the European System of Central Banks (ESCB) and the European Central Bank (ECB). The basis of the common monetary policy is laid down in the Treaty of European Union and the statue of European System of Central Banks and of the European Central (Belke and Volz 2015). The formal aspect of the ECBS has two levels the European Central Bank and the national central banks of the member states and this together constitutes the “euro system”. The functioning of Euro system is governed by the principles of decentralized execution of monetary policy (Bennani and Neuenkirch 2015). The European Central Bank is responsible for coordinating the operations and the National Central Banks are responsible for carrying out the transaction like providing funds to the bank, settlement of payments and management of foreign reserve operation (Burda and Wyplosz 2012).
The Euro System constitutes both the European Central bank and the national central banks of the member states (Campiglio 2016). The primary objective of the Euro system is to maintain price stability. To attain this objective the European Central Bank and the associated national central banks supports the general economic policy for sustainable development of Europe based on the equitable economic growth and stability of the price (Carpenter et al. 2014).
The responsibility of the European Central bank along and the overall Euro system are the following (Carpenter et al. 2013):
- Understanding and implementing the monetary policy;
- Monitoring and conducting of foreign exchange operation;
- Management of the euro area foreign currency reserves;
- Implementing the smooth operation of payment system across Europe;
In addition to this European Central Bank is also responsible for supervision of banking system, bank notes, statistics and financial stability along with the international and European cooperation (Cassola and Koulischer 2014).
The primary objective of the European Central Bank is to maintain price stability and it is the single most important monetary policy for which it exists. In order to achieve this objective the implementation of ECBs monetary policy is depended on two pillars (Chen et al. 2012). The first pillar is the monetary policy strategy and the second pillar is the operational framework. The monetary policy strategy determines the level of interest that is required to maintain price stability over the medium term (Claeys et al. 2014). The operational framework is the instruments and procedures that European Central Bank uses to achieve its desired rate of interest (De Haan and Eijffinger 2012).
ECB follows a strategy of analyzing the risk in the euro zone with respect to price stability. The strategy includes a quantitative analysis of price stability along with the economic and the monetary analysis of risk to price stability in the region (Dincer and Eichengreen 2013). These are the two main elements that provide the ECB with the framework for assessment of information and decision-making (Égert and KoÃÂenda 2014).
It is the primary objective of the European Central Bank but it is not specifically stated in the treaties. Therefore, to obtain clarity the ECB has decided to define the price stability quantitavely (Fiore and Tristani 2013). In definition, it provides that its aim is to maintain inflation below or close to 2% in medium terms. The definition has helped to increase the clarity and transparency of the ECBs monetary policy (Galati and Moessner 2013). It aims to maintain the price stability for the medium term. It is justified that the policy focuses on medium term because there is a time lag between formulation of monetary policy and the effect of actual changes in the price level (Goodhart 2014). If the monetary policy were framed for short term then it would create price volatility instead of price stability (Henning 2015).
The Monetary Policy of the European Central Bank
Economic and monetary analysis
The monetary policy decision of the European Central Bank is based on the economic and monetary analysis. The economic and monetary analysis both are complementary to each other (Howarth and Högenauer 2016). The economic analysis focuses on short term whereas the monetary analysis focuses on the medium term. They both act as cross checks to reduce the policy error caused by over reliance on single model (Howarth and Quaglia 2013).
The economic analysis focuses on the assessment of the current economic and financial trends. It also analyses the short to medium term risks that the economic and financial conditions presents for the price stability (Joyce et al. 2012). The main objective of the analysis is to identify the shocks that affect the economy. The analysis are based on the trends in the global economy, development in productions, demand for services and goods, conditions of the labor market and the financial market conditions (Kirkegaard 2014). In addition to this, the ECB also carries out several surveys that provide additional input into the economic analysis (Kuhn and Stoeckel 2014).
The analysis of the monetary policy focuses on the medium to long term. In this detailed analysis of monetary and credit trends along with the implications for inflation and economic growth are studied (Lane 2012).
The European Central bank uses various monetary transmission mechanisms through which the monetary policies are channelized to affect the price level and the economy in particular (Merler and Wolff 2013). It is done in two stages the first stage is to change the interest rate which in turn affects the market interest rate, asset prices, exchange rate and the credit situation in general (Moravcsik 2012). The second stage is the affect that changes in the first stage has on the overall spending ability of the households, firms and companies. The main instrument the European Bank has to affect the economy is the official interest rate (Oldani 2012). The rates that are determined by the ECB are the interest rate on main refinancing operations, the rate on the deposit facility and the rate on the marginal lending facility. The ECB has also various introduced non-standard policy measures after the recent financial crisis (Pelizzon et al. 2016). The framework of operation has the following set of instruments open market operations, standing facilities and minimum requirement of reserve to be maintained by the credit institutions (PolaÃ âski 2016).
The ECB’s Monetary Policy Strategy
Open market operations
The open market operations perform an important role in steering interest rates, it also helps in managing the liquidity of the market and it signals the stance on monetary policy. Five types of instrument are available in the euro zone for open market operations (Reichlin 2013). The most important instrument among them is the reserve transactions that are conducted in the form of repurchase agreement or as a collateral loan (Schularick and Taylor 2012). The other instruments it uses are outright transactions, debt certificates, fixed term deposits and foreign exchange swaps (Szczerbowicz 2015). The ECB initiates open market operations and it decides the terms and conditions of the instrument. The open market operations are executed based on bilaleteral procedures, standard tenders and quick tenders (Van Rompuy 2012).
There are primarily four types of open market operations main refinancing operations, long term refinancing operations, fine-tuning operations and structural operations. The main refinancing operations are liquidity providing transaction conducted by ECB (Wallace et al. 2015). It plays an important part in fulfilling the objectives of the ECB and it is responsible for the largest share of refinancing to the financial sectors. The longer term refinancing has longer maturity time than the main refinancing operations (Welfens 2012). The primary objective of longer term refinancing is to provide additional refinancing for the long-term and to serve other objectives of monetary policy (Friedman 2015). The fine tuning operations have the option to be executed on ad hoc basis so that the liquidity situation in the market could be managed by steering interest rates. This are executed normally through tenders or bilateral procedures (Albu et al. 2014). The structural operations are conducted through reverse transactions, out right transactions and the issue of the debt certificates.
The aim of the standing facility is to provide and absorb liquidity, provide a general overview of the monetary policy and to bind market interest rates. There are two standing facilities that are administered by National Central Bank and they are marginal lending facility and deposit facility (Alessi et al. 2014). The marginal lending facilities helps to obtain overnight liquidity from the National Central banks against assets that are eligible. The interest rates on the marginal lending acts as the threshold limit for the overnight market interest rate. The deposit facilities can also be used to make overnight deposits with the National Central Banks (Allard et al. 2013).
The minimum reserve is the integral aspect of the operational framework of the monetary policy of the euro zone (Aysan et al. 2014). The main purpose of the minimum reserve system is to satisfy the objective of stabilizing the interest rates and to create a shortage in liquidity in a structural manner. The reserves to be maintained by various institutions are determined by the position of their balance sheet (Bauer and Neely 2014).
Asset Purchase Programmes
The expanded Asset purchase program addresses the risk of prolonged period of low inflation. It consists of public sector purchase program, third covered bond purchase programme and asset backed securities purchase programme (Belke and Volz 2015).
Euro has acquired a significant position in the international market but this leads to face euro with the challenges of the economic policies. As a denomination of the issues relating to international level, euro has a prominent role (Bennani and Neuenkirch 2015). One of the primary objectives of the European central bank is to maintain stability in the price. ECB based its monetary policy in reference to the stabilizing the currency into two pillars. The first focuses on the shorter term and the second focuses on the medium to long term (Carpenter et al. 2014).
A number of external factors and domestic factors determine the exchange rate. When there is a change in interest rate, which is when the interest rate rise, the domestic currency becomes more attractive to the international investors (Bradley 2014). This leads to the appreciation of currency. The change in exchange rate affects the inflation of any country and this is due to the lower price of imported goods. The competitiveness of the domestic product gets affected when the currency is appreciated or depreciated (Burda and Wyplosz 2012). The monetary policy has a transmission mechanisms and it consists of various channel thorough which price is stabilize (Henning 2015). The exchange rate channel is one of such channel that affects the exchange rate help in stabilizing.
The monetary policy concerning the exchange rate does not embodies the target of euro rate and it mainly focuses on the price stability and its maintenance in the euro is facilitated by the strategies of the policies regarding the exchange rate (Campiglio 2016). The general strategy is to rule out the implicit or explicit rate of euro. The policy adhered by ECB is of benign neglect during a phase when there was a euro vis-à-vis dollar depreciation in the year 1999 (Carpenter et al. 2014).
Economic and Monetary Analysis
Since the birth of the European central bank, the fundamental principle guiding the strategy of the bank has not changed significantly. Maintaining the price stability is the fundamental strategy of the European central bank (Carpenter et al. 2013). This is because the price stability is beneficial in several aspects. The central bank used the tools such as the interest rate to adjust the supply of money (Cassola and Koulischer 2014). Monetary policy is also the useful policy used by ECB for achieving the growth objectives. The instruments and tools include the development of the monetary aggregates and this is done by comprehensive analysis (De Haan and Eijffinger 2012). The transmission mechanism is used by the central bank that affects the price level and the economy in particular. The first stage of this mechanism consists of changes in the rate of base money or the interest rate and this ultimately affects the price level, exchange rate and the interest rate as well (Dincer and Eichengreen 2013). The official interest rate is the main lever the central bank has at its disposal (Bradley 2014). This is done by making provision of funds to the banks which is one of the key operations of the bank. This impacts the interest rate of the money market and this leads to the change in the expectation of the future rate of exchange. In the year 2012, the European central bank announced the program of sovereign bond purchasing called Outright Monetary transactions and the objective of this program was to repair the transmission mechanism of the monetary policy so that the homogenous credit conditions throughout the Euro zone is restored (Égert and KoÃÂenda 2014). The purchase of such type of sovereign debt is intended to reduce the risks premier regarding the possibility of reversibility of the Euro (Fiore and Tristani 2013).
The other monetary policy operation that aims to absorb the liquidity overnight is the standing facilities. The standing facilities are of two types. Deposit facility mad marginal lending facility (Friedman 2015). The rate on the marginal lending facility rate is comparatively higher than the money market rate. So the only option available to the credit institutions is the deposit facility (Galati and Moessner 2013). The rate on the deposit facility and the marginal lending facility normally provides a floor and the ceiling in the money market. When the government determines the rate for the standing facilities, it is setting corridor for the rate of money market to operate (Goodhart 2014).
Minimum reserves is another tools used by the European Central Bank in stabilizing the interest rate of the money market and ultimately stabilizing the euro currency. Under this tool, all banks in euro zones are required to hold minimum reserves of certain amount (Henning 2015). The amount to be kept as reserves is calculated in relation to items such as deposits in the balance sheets of the banks account (Howarth and Högenauer 2016). The banks are able to stabilize the interest rate in the money market using such reserves. This is done by providing the institutions an incentive to smooth the consequences of the liquidity fluctuations, which is arising on a temporary basis (Joyce et al. 2012). This would enhance the liquidity shortage of the banking system. Through the open market operations, it would be possible for the Euro Central bank would be able to steer the rates of money market (Kirkegaard 2014). This would be because the ECB is offering liquidity to the banks at such rate, which is aligned to the policies of the banks, and thus the money market rate is getting influenced (Lane 2012).
Quantitative easing also known as asset purchase program aims at reviving the area of economy of Euro area. This is new policy instrument and unconventional tool (Merler and Wolff 2013). Under this tool, the European Central bank purchase euro denominated and securities that are of investment grade from the European institution or the Euro area government to create new money (Moravcsik 2012). The plan is expected to have a positive impact on the performance of the economy. The process is very advance and does not involve printing of any bank notes. It is performed electronically (Pelizzon et al. 2016). The ECB increase the credit in its account by creating the money. The low or stable interest rate would prompt the investors and they would look for better yield on the bonds elsewhere. This would have impact on the domestic currency and the lower value of currency would boost the exports (PolaÃ âski 2016).
The European monetary union makes the euro area less vulnerable to the instability of the overall exchange rate. In order to stabilize the foreign exchange market, the ECB has developed a comprehensive framework of its exchange rate policy (Reichlin 2013). ECB has introduced an intervention policy by stopping the appreciation of euro and this is done by announcing the upper limit of the dollar exchange rate (Schularick and Taylor 2012). This strategy relies on the signaling channel and the portfolio balance channel of intervention. Under this type of intervention, the central bank is engaged in buying and selling of the foreign exchange and this leads to the adjustments of the portfolio of the private sector (Van Rompuy 2012). The signaling channel market information about the future monetary policy is provided by the central bank and this stabilizes the expectations of the exchange rates (Welfens 2012). This intervention policy has two directions and they are:
When the euro appreciates, the central bank tries to limit the appreciation. The bank buys foreign exchange against the deposits of central bank, which it cannot supply with the quantitative limit (Galati and Moessner 2013).
The intervention of ECB forms preventing the appreciation of Euro vis-à-vis dollar. The rates of the domestic money market that is required to maintain the stability of price in the Euro area, ECB has its deposits facility disposed (Henning 2015). This facility does not have any limit, so the monetary conditions cannot be affected in the euro area.
The ECB tries to defend the currency against the market pressure in the event of depreciation. This type of defend is performed under the constraint of the reserves of the foreign exchange (Howarth and Högenauer 2016).
However, it is utmost important to analyze the intervention policy affecting the price in the euro area. Intervention of the ECB in the foreign exchange market would have a direct impact on the monetary base (De Haan and Eijffinger 2012). When the monetary base increases then there is creation of deposit facility by ECB for the specific purpose. The interest rate would determine the rate in the money market in the euro area (Égert and KoÃÂenda 2014). When the monetary base decreases and this happens by providing credits to the commercial banks. If the ECB operates with the marginal lending facility, such compensation would be provided automatically (Galati and Moessner 2012). There also exists bilateral arrangement of the intervention policy. The policy of unilateral exchange rate of ECB would be able to contribute to the employment and growth without affecting price stability in the euro area. When there is a uncontrolled depreciation of the exchange rate say, euro versus dollar then the ECB has a limited room for maneuver (Henning 2015). Therefore, this calls for bilateral agreement between the euro area and another company say, United States. This would leads to the creation of exchange rate band where the euro/dollar rate would swing or the rates would fluctuate in limits (Howarth and Quaglia 2013). The difficulties of identifying the equilibrium rate of exchange would be depicted in the width of the band of the exchange rate.
The intervention is carried out by ECB directly in a centralized manner. The interventions of foreign exchange can take place within the exchange rate mechanism framework that is exchange rate mechanism II. This is based on the legal documents (Kirkegaard 2014).
The dotcom bubble busted in 2002 and the global economy faced a serious economic crisis. This event affected both the US and European economy but interestingly US markets were able to regain its strength whereas in Europe the economy continuously suffered from low growth rates (Moravcsik 2012). The main reason for this disparity in economic recovery is due to the policies of the European Central Bank. The performance of ECB between the period 1999-2000 shows that interest rates were set higher during this period (Pelizzon et al. 2016). This policy was not in accordance with the final domestic demand because increased interest rate has a cascading effect. The increased interest rate means that there will be fewer borrowings from bank by the companies, which eventually means that there will be less investment, as a result low economic growth (Reichlin 2013). Therefore, it can be argued that for the first few years the performance of the ECB was below the expectations. It can also be argued that ECB has performed well as it has been successful in maintaining inflation rate near 2% in the last two years of the period (Schularick and Taylor 2012). The ECB would have achieved its target of maintaining inflation below 2% but failed due to tax pull inflation. The restrictions of the stability and growth pact (SGP) are the main cause of tax pull inflation. It forces the governments either to cut spending or increase taxes in order to fulfill its objectives (Van Rompuy 2012). The ECB however cannot be directly blamed for this but it can also be said that there is a link between the monetary policy of the ECB and the SGP which cannot be completely denied. The situation started improving and by 2007, the interest rate of the ECB was completely in aligned with the domestic growth rates (Bauer and Neely 2014). The economic conditions in Europe were in upswing during this period but in 2007, a period of economic crisis again ensued. The ECB again increased its key interest rate as a result the investment in the economy decreased (Bennani and Neuenkirch 2015). This policy was of ECB was criticized by different quarters as it reacted slowly in the emerging financing crisis and its policy of increasing interest rate was also criticized. In the time of crisis, the policies of the ECB to increase interest rates greatly diminished the capability of the European countries to recover from the slowdown (Campiglio 2016).
The most important element of the strategies implemented by the ECB is that it gives importance to money. It was important because the availability of money from the macroeconomics was diminishing during the period (Chen et al. 2012). The strategies implemented by the ECB were primarily based on the assumptions provided in the quantity theory. Therefore, it used its independence to fix a money supply rate to attain its objective of attaining price stability (Dincer and Eichengreen 2013). The analysis of the performance of the ECB highlights that there are few deficiencies that are needed to be addressed. It can be argued that the key interest rates set by the ECB are high and it is adversely affecting the economic growth of the Europe (Friedman 2015). The European monetary policies are not conducive and are far from being sound. The inefficient and non-transparent decision making structure of the ECB was highlighted during the recent financial crisis (Galati and Moessner 2013). The monetary policies of the European central bank prior to the crisis contributed to the economic imbalance in the Europe. The policies during the Greek crisis were pragmatic but there is a need of reform in the governing council of the ECB so that accountability and transparency can be ensued in the system (Henning 2015). The future of the ECB is dependent on its ability to adapt with the emerging challenges within the European Union.
The ECB has adopted various unconventional and untested monetary measures along with the Asset purchase program to avoid the liquidity crisis in the financial sector and to avoid break up of European Union (Howarth and Högenauer 2016). The purpose of the monetary policy is to encourage the investors in taking risks. The excessive risk taking can however be the cause of future financial crisis. The lessons learned from the global economic crisis shows that the price stability by in itself could not ensure financial stability (Joyce et al. 2012). Therefore, a broad Conesus has emerged financial stability should be addressed ex ante. It can be said that monetary policy is not helpful in addressing the financial crisis it should primarily focus to its main objective of maintain price stability (Lane 2012). The credibility of the ECB is based on the fulfilling of this objective.
The monetary policy of the ECB has failed to meet the targets and it failed to tap the full growth potential of the European economy. Many attempts have been made to reform the European Central Banks functioning by the academic writers (Reichlin 2013). The most common proposal is to introduce more accountability and to make the administrative system of ECB more democratic. There is also a need to provide the right to the European parliament to define price stability in order to make it more accountable (Szczerbowicz 2015). This would not only make the decision making democratic but also provide a higher legitimacy to the decision. The second proposal is to reform the decision making process of the ECB. The restructuring of the council is therefore needed for smooth functioning (Van Rompuy 2012). A system of rotation should be implemented by reserving the permanent seats for few large countries so that the discourse is not only dominated by smaller countries (Welfens 2012).
In the report it is presented that, the ESCB has two level systems they are European Central bank and the National Central Banks. In this two level structure the ECSB overlooks the joint existence of the ECB and the national Central Banks. The ECB also has legal personality status that helps to fulfill its aims and the monetary policy targets. In order to achieve this aim it has a wide range of monetary policy instruments. They are open market operations, standing facilities, creation of the minimum reserves etc. The aim of these instruments is to influence the market interest rates and the liquidity of the financial sector in order to guide the monetary policy. These policy instruments have been playing a pivotal role in the development of the banking system in the domestic and the international market. The decision making power is in the hands of the ECB but the implementation of it depends on the national banks.
The economic philosophy of the European Central Bank is that in the long run the real economy is not determined by the available liquidity. The primary objective of the monetary policy is to achieve short-term price stability and thereby achieving economic growth. The ECB intervenes in a centralized manner to affect the price of the euro zone. This intervention is done within the foreign exchange rate mechanism framework. The evaluation of the historical performance of ECB shows that in time of crisis the policies of the ECB was helpful. At the same time this policies also slowed down the recovery rate of the economy.
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My Assignment Help. 'Evaluation Of The Monetary Policy For Stabilizing The Euro Currency' (My Assignment Help, 2017) <https://myassignmenthelp.com/free-samples/evaluation-of-the-monetary-policy-stabilizing-the-euro-currency> accessed 29 February 2024.
My Assignment Help. Evaluation Of The Monetary Policy For Stabilizing The Euro Currency [Internet]. My Assignment Help. 2017 [cited 29 February 2024]. Available from: https://myassignmenthelp.com/free-samples/evaluation-of-the-monetary-policy-stabilizing-the-euro-currency.