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MONETARY POLICY

MONETARY POLICY. Valanta Milliou cmilliou@aueb.gr http://www.aueb.gr/users/milliou/teaching.html. Definitions.

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MONETARY POLICY

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  1. MONETARY POLICY Valanta Milliou cmilliou@aueb.gr http://www.aueb.gr/users/milliou/teaching.html

  2. 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 interestrate, 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.

  3. 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.

  4. 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".

  5. 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.

  6. 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;

  7. 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 year-on-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".

  8. History Review 1979: The European Monetary System (EMS) and The Exchange RateMechanism (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.

  9. 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 member-states (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)

  10. History Review Convergence criteria: 1. Price Stability: An average inflation rate not exceeding by more than1.5% that of the three best-performing member-states. 2. Interest Rate Convergence: An average long-term interestrate not exceeding by more than 2% that of the three bestperforming member-states. 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 nodevaluations.

  11. History Review 1994: Start of Stage 2; European Monetary Institute set up in Frankfurt. 1998: Decision by European Council on who meets convergence criteria: 11countriesin starting group. 1999: Start of Stage 3; ECB takes over monetary policy from national centralbanks; 2002: Introduction of Euro coins and banknotes.

  12. 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.

  13. 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.

  14. 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 long-term 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.

  15. 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.

  16. 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.

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