1. 1 News Analysis Assignment  Follow news on topics related to EU, EMU (or economic integration elsewhere) Read newspapers, magazines Search the internet Articles do not have to be about the same topic; this time no logic required…  Based on theories/concepts learned during the course, explain the economics behind the stories -Show me that you have learned some economics during the course! -See for example group work today on news on ECB’s interest rates  Include the news as an appendix in your report  Report (excluding appendices, cover page and table of content) should be maximum 10 pages -DL Mon Nov 3rd, send to an.chen@aalto.fi and riikka- leena.leskela@nhg.fian.chen@aalto.firiikka- leena.leskela@nhg.fi -INDIVIDUAL assignment – DO NOT copy text directly (not from Internet or any other source)

2. 2 Is EMU an OCA?  In groups, collect your findings -Openness Intra-industry trade or specialization? -Business cycle correlation GDP changes Inflation -Financial markets & institutions -Labor markets -…  In your opinion, is EMU above the ”OCA line”?

3. 3 Today’s Agenda  Monetary Policy -Goals and tools -Transmission mechanism of monetary policy  The European Central Bank -Goals of ECB -Challenges

4. 4 Monetary Policy = Actions of a central bank to control the supply of money  Goals -Stabilize economy (low inflation) -Support economic growth  Tools -Interest rate Open market operations Standing facilities -Minimum reserve requirements

5. 5 Transmission Mechanism  The mechanism through which the central bank’s actions affect the economy and ultimately the price level -Complex -Time lags

6. 6 Transmission Mechanism Illustrated OFFICIAL INTEREST RATES Expectations Bank and Market Interest Rates Asset Prices Exchange Rate Supply & Demand in Goods & Labor Markets Domestic Prices PRICE DEVELOPMENTS Import Prices Wage & Price Setting Money, Credit Shocks from outside the control of the central bank Changes in global economy Changes in fiscal policy Changes in commodity prices

7. 7 European Central Bank  ECB, ”Eurosystem”, and ESCB  Decision-making in ECB -Governing council and executive board -General council -Independence from politics  Established in the Maastrict Treaty: -Primary objective to ”maintain price stability” -Secondary objective to ”support general economic policies in EU” High level of employment, sustainable growth, high degree of competitiveness  Comparison to the anglo-saxon model

8. 8 Specifying ECB’s Goals  What is meant by ”price stability”? -ECB’s definition: Inflation close but not above 2%  If inflation is bad, why not aim at 0%? -Inflation keeps economy going when wages are sticky -Bias in HICP -> true inflation less -Regional differences within EMU -Risk of deflation

9. 9 How Are Policy Decisions Made?  Two pillars strategy -Economic analysis -Monetary analysis  ECB takes actions to ensure price stability in the medium to long term -Due to lags, monetary policy cannot react to shocks in the short term  Accountability?!  Transparency and communication of policy

10. 10 Challenges for ECB  ”One policy fits all” -How to maintain price stability in all regions? -ECB follows euroarea aggregates -> large countries weigh more  Pressures from politicians and other lobbyists  Credibility and reputation -How to establish when no track record?

11. Financial Crisis 2008  Started from the U.S. -Housing market and subprime loans turned into investment instruments -Defaults and declining prices caused huge losses for banks and investors  Problem: trust between banks disappeared -Interbank money market froze -Banks couldn’t get money so they could not lend it to firms or consumers No invesments, low confidence => recession 11

12. ECB in the Financial Crisis  ECB took emergency measures -Acting as an intermediary in the interbank money market -Longer term financing guaranteed for banks -Decrease in the interest rate  New duties for the ECB: regulation of financial institutions, e.g. ”stress tests” for banks -Discussion on more regulation of the financial markets 12

13. Debt Crisis since 2011: Implications for ECB  Although a problem of national governments, the debt crisis affects ECB  Insolvency of one member can affect the credibility of other members -Also the credibility of the ECB is at risk: can it maintain price stability?  Problems for commercial banks -Banks use their ”low risk” investments as collateral when borrowing from ECB -When banks incur losses, their ability to gain finanancing is compromised Potential liquidity problem similar to the financial crisis  ECB has had to purchase government bonds to calm the markets -The ECB is not supposed to purchase government bonds to maintain its independence from national governments 13

14. 14 Group Work  Read the news item from September 2014 from the Wall Street Journal reporting on the outlook on ECB’s monetary policy -What is the economics behind the story? Why did ECB lower the interest rates? What are the current challenges for the ECB? What are the effects of the decision?

15. 15 Pre-Lecture Assignment 1. How successful has ECB’s policy been? Evaluate the success of ECB from several view points. -Find data on the development of ECB interest rates, EMU inflation and GDP growth of EMU countries -You can read selected parts from ECB’s 10 year anniversary publication "Special edition of the Monthly Bulletin". May 2008. http://www.ecb.int/pub/pdf/other/10thanniver saryoftheecbmb200806en.pdf http://www.ecb.int/pub/pdf/other/10thanniver saryoftheecbmb200806en.pdf 2. What do you think the ECB’s challenges will be in the near future?