1. Feb 24 2004 Lesson 6 By John Kennes International Monetary Economics

2. Feb 24 2004 The European Monetary Union

3. Feb 24 2004 The launch of the euro represents the end of a long process

4. Feb 24 2004 A firm commitment to launch the single currency by January 1999 at the latest. A list of five criteria for admission to the monetary union. A precise secification of central banking institutions. Additional conditions mentioned (e.g. The excessive deficit procedure). The Maastricht Treaty

5. 1.Inflation –Not to exceed by more than 1.5% the average of the 3 lowest. 2.Long-term interest rate –Not exceed by more than 2% the average of the low 3 above 3.ERM membership –At least 2 years in ERM without being forced to devalue 4.Budget deficit –Deficit less than 3% of GDP 5.Public debt –Debt less than 60% of GDP The Maastricht Convergence Criteria

6. Feb 24 2004 Inflation criteria: A fear of allowing in unrepentant inflation-prone countries

7. Feb 24 2004 Too easy to bring down inflation in 1997 – artificially or not – then let go again. Long-term interest rates incorperate bond market expectations of long term inflation. So criteria requires convincing markets Problem: self-fulfilling prophecy –If markets believe admission to euro area, they expect low inflation and long-term interest rate is low, which fulfills the admission criteria –Conversely, if... Long-term interest rate criteria: A little too easy to bring inflation down in 1997

8. Feb 24 2004 Need to convince the exchange market. Need to show a non-superficial conversion to price stability. Membership demonstrates the countrys ability to keep its exchange rate tied to its future monetary union partners Problem: same aspect of self-fulfilling prophecy ERM membership: same logic as long-term interest rate criteria

9. Feb 24 2004 Historically, all big inflation episodes born out of runaway public deficits and debts. Hence requirement that house is put in order before admission How are ceilings choosen? –Deficit: the German golden rule (public infrastructure investment about 3% of GDP) –Debt: the 1991 EU average Budget Deficit and debt criteria: historical view

10. Feb 24 2004 Problem No. 1: A few years of budgetary discipline do not guarantee long-term discipline: –The excessive deficit procedure will look to that once in the euro area, more later. Problem No 2: Artificial ceilings –The Belgium clause Budget Deficit and debt criteria: Problems

11. Feb 24 2004 Budget Deficit and debt criteria: in 1997

12. Feb 24 2004 N countries with N central banks (NCBs) that continue operating but with no monetary policy function A new central bank at the centre: the European Central Bank (ECB) The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=15) The Eurosystem: the ECB and the NCBs of euro area member countries (N=12) A tour of the Acronyms

13. Feb 24 2004 The System

14. Feb 24 2004 Objectives –What is it trying to achieve? Instruments –What are the means available? Strategy –How is the system formulating its actions? How does the Eurosystem operate?

15. Feb 24 2004 The Maastricht Treatys Aricle 105: –The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contibuting to the achievement of the Community as laid down in Article 2. In clear –Fighting inflation is the absolute priority. –Supporting growth and employment comes next. Objectives (1)

16. Feb 24 2004 Making the inflation objective operational: does the Eurosystem have a target? No, it has a definition of price stability. –`Price stability is defined as a year-on-year increase in the HarmonizedIndex of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term´ –`The governing council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. Objectives (2)

17. Feb 24 2004 Leaves room for interpretation –Where below 2 per cent? –What is the medium term? Objectives (2) comment

18. Feb 24 2004 Recall the channels of monetary policy –Longer run interest rates –Credit –Asset prices –Exchange rate These are all beyond the central bank control Instead it can control the very short-term interest rate: European overnight Index (EONIA) EONIA affects the channels through market expectations Instruments (1)

19. Feb 24 2004 The Eurosystem controls EONIA by establishing a ceiling, a floor and steering the market in-between. –The floor: the rate at which the Eurosystem accepts deposits (the deposit facility) –The ceiling: the rate at which the Eurosystem stands ready to lend to banks (the marginal lending facility) –In-between: weekly auctions (main refinancing facility) Instruments (2)

20. Feb 24 2004 EONIA & Co.

21. Feb 24 2004 The monthly Eurosystems interest rate decisions (every month) rests on two pillars. Economic analysis –Broad view of economic conditions: Growth, employment, exchange rates, abroad Monetary analysis: –Evolution of monetary eggregates (M3, etc.) The Two-Pillar Strategy

22. Feb 24 2004 The US Fed: –Legally required to achieve both price stability and a high level of employment –Does not articulate an explicit strategy Inflation-targeting central banks (Czech Republic, Poland, Sweden, UK, etc): –Announce a target (e.g. 2.5% in the UK, a margin (e.g. +/- 1%) and a horizon (2-3 years) –Compare inflation forecast and target and act accordingly Comparison with other strategies

23. Feb 24 2004 Taylor rule: i=i*+a( *)+b(y-y*) –where i* is the equilibrium interest rate, is the inflation rate and * the inflation objective, y is the GDP growth rate and y* is the GDP growth trend. –Central bank raises interest rates if inflation exceeds target. Using the Fisher principle: i*=r*+ * –Take: *=2% and i*=4% (2% real, 2% target inflation) –Choose a and b: a=2.0, b=0.8 (care about both inflation and cyclical flucuations with emphasis on latter) Compare with the actual EONIA Taylor Rule Interpretation: Suppose ECB sets interest rates by the Taylor Rule

24. Feb 24 2004 A Reasonable Fit: Suppose ECB sets interest rates by the Taylor Rule

25. Feb 24 2004 With one monetary policy, particular national conditions cannot be attended to. This is another version of the asymmetric shock concern of the OCA theory: the cost must be borne. Monetary policy may also effect differently different countries. Does One Size Fit All?

26. Feb 24 2004 Current conventional wisdom is that central banks ought to be independent: –Government tend not to resist to the `printing press´ temptation –The Bundesbank has set an example But misbehaving governments are eventually punished by voters What about central banks? Independence removes them from suc pressure A democratic deficit? Independence and Accountability

27. Feb 24 2004 In return for their independence, central banks must be held accountable –to the public –to elected representaives Examples: –The Bank of England is given an inflation target by the Chancellor. It is free to decide how to meet the target, but it must explain its failures (the letter) –The US Fed must explain its policy to Congress, which can vote to reduce the Feds independence Redressing the Democratic Deficit

28. Feb 24 2004 The Eurosystem must report to the EU parliament The Eurosystems President must appear before the EU Parliament when requested, and do so every quarter But the EU Parliment cannot change the Eurosystems independence and has limited public visibility The Eurosystem Weak Accountability

29. Feb 24 2004 A difficult period –An oil shock in 2000 –A worldwide slowdown –September 11 –The stockmarket crash 2002 –Afghanstan, Iraq The Record So Far

30. Feb 24 2004 Inflation: Missing the Objective a Little

31. Feb 24 2004 The Euro: Too Weak First, Then too Strong?

32. Feb 24 2004 But No Seriously Asymmetric Shocks

33. Feb 24 2004 Discussion of the class project. –Choice of topic and coauthor (3 or 4 questions per topic from a set of 6 topics, optional 7 th project) –Project format (3000 words etc) –Web Publication of Projects (names will be withheld) –Referee reports (300-400 words) –Web publication of referee reports (names will be witheld) –JEH Next class