Monetary Policy of the ECB Term Paper

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" (ECB, 2007)

Operational efficiency is held to be the most important of all the principles of operation for the ECB and can be defined as "the capacity of the operational framework to enable monetary policy decision to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level." (ECB, 2007) Equal treatment and harmonization is a principle that holds that credit institutions must be treated equally regardless of their size or their location in the euro area. Simplicity and transparency are said to "ensure the intentions behind monetary policy operations are correctly understood. The principle of continuity aims at avoiding major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystem's financial and operational risks are kept to a minimum. Cost efficiency means keeping low the operational costs to both the Eurosystem and its counterparties arising from the operational framework." (ECB, 2007) the following chart illustrates the primary transmission channels of monetary policy decisions.

Primary Transmission Channels of Monetary Policy Decisions

Source: ECB (2007)

Change in official interest rates takes place through the central bank providing funding to the banking systems and charging interest. The central bank can make full determination of this interest rate due to its monopoly power of issuance of money. The affects to banks and money-market interest rates is one of a direct nature in terms of money-market interest rates and of an indirect nature in terms of lending and deposit rates which the banks themselves set for customers. In terms of expectations of future official interest-rate changes and the affect on medium and long-term interest rates specifically, the longer-term interest rates are dependent, at least in part, on the expectations of the market concerning short-term rates future course. Also guided by monetary policy can be the economic agents' expectations related to future inflation and this has an influence on developments in prices. If the central bank has credibility of a high nature then it is able to firmly anchor price stability expectations and this enables economic agents to avoid increase of prices in anticipation of higher inflation and reduces the fear associated with deflation. In terms of the effect on asset, prices it is stated that: "The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels." (ECB, 2007) the impact of changes in interest rates are illustrated in the decision of households and firms. Consumption and investment are also affected by changes in asset prices via wealth effects and effects on collateral value. The example given is: "...as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premium demanded by lenders/banks." (ECB, 2007) the effect to the supply of credit is that higher interest rates bring on an increase in the risk that borrowers will not be able to pay back their loans and thus the bank is likely to cut back on the funds that are loaned to households as well as to firms. Changes in aggregate demand and prices are affected by changes in consumption and investment, which in turns changes the "level of domestic demand for goods and services relative to domestic supply." (ECB, 2007) it is related that when supply is exceeded by demand that "upward pressure is likely to occur..." As well as "changes in aggregate demand may translate into tighter or looser conditions in labor and intermediate product markets. This is turn can affect price and wage-setting in the respective market." (ECB, 2007)

III. ECB BASIC TASKS

The basic tasks of the Eurosystem are: (1) Definition and implementation of the monetary policy in the euro area; (2) the conduct of foreign exchange operations; (3) the holding and management of the official foreign reserves of the member states; and (4) the promotion of the smooth operation of payment systems.

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" (the Monetary Policy of the ECB, 2004) the following illustrates the decision-making bodies of the ECB.

The Decision-Making Bodies of the ECB

Source: The Monetary Policy of the ECB, 2004

The Governing Council of the ECB is stated to "consists of the six members of the Executive Board the governors of the euro areas NCBs (12 governors as of 2003). " (the Monetary Policy of the ECB, 2004) the President of the ECB chairs both the Governing Council and the Executive Board and when absent the Vice-President fills this role. The responsibilities of the Governing Council are: (1) the adoption f the guidelines and taking the necessary decisions for ensuring the performance of the tasks entrusted to the Eurosystem; and (2) the formulation of the monetary policy of the euro area. (the Monetary Policy of the ECB, 2004; paraphrased) the Executive Board of the ECB is comprised of the President and Vice-President as well as four other members all of which are appointed by the Head or State of Government for the euro area countries. The Executive Board is responsible for: (1) preparing the meetings of the Governing Council; (2) implementation of monetary policy in accordance with the guidelines and decisions laid down by the Governing Council; (3) the current ECB business; and (4) assuming certain power delegated to it by the Governing Council, which may include power of a regulatory nature. (the Monetary Policy of the ECB, 2004; paraphrased) the General Council of the ECB is comprised of the President and Vice-President of the ECB and the governors of the NCBs of all EU Member States. The General Council does not have any responsibility for monetary policy decisions in the Euro area. The central bank is independent from political influence due to the institutional framework for the single monetary policy. Stated is: "A large body of theoretical analysis, supported by substantial empirical evidence, indicates that central bank independence is conducive to maintaining price flexibility." (the Monetary Policy of the ECB, 2004) the important principles of central bank independence are laid out in Article 108 of the Treaty. While exercising the powers and carrying out tasks and duties appointed them, "neither the ECB nor the NCBs, nor any member of their decision making bodies are allowed to seek or take instructions from Community institutions or bodies, from any government of a Member Sate or from any other body." (the Monetary Policy of the ECB, 2004) Furthermore, this principle must be respected by Community institutions, bodies, and governments of Member States who must not "seek to influence the members of the decision-making bodies of the ECB." (the Monetary Policy of the ECB, 2004) Other safeguards include the fact that the ECB's financial arrangements are separately kept from those of the European Community." (the Monetary Policy of the ECB, 2004) Another safeguard is through the ECB having its own budget with the "...capital subscribed and paid up by the euro area NCBs." (the Monetary Policy of the ECB, 2004)

IV. CURRENT BEST PRACTICE: PREDICTABILITY he work entitled: "The Predictability of the ECB's Monetary Policy" states that: "Current best practice in monetary policymaking, as embodied in the monetary policy framework of the ECB, emphasizes the desirability of a high level of predictability in central bank decisions. A distinction can be made between the notions of short-term and longer-term predictability. Short-term predictability is achieved when the public is in a position to anticipate correctly the central bank's next monetary policy decisions. A more fundamental aspect of monetary policy predictability relates to its longer-term dimension, which requires that the public has a genuine understanding of the central bank's monetary policy framework and its behavior over time. A high degree of predictability of interest rate decisions is the result of monetary policy being conducted in a credible and transparent manner that is well explained to the public. Hence, while predictability broadly understood is not an objective per se, it enhances the effectiveness of monetary policy and contributes to accountability vis-a-vis the public at large." (nd) Predictability is said to reduce uncertainty concerning interest rates and results in the facilitation of asset pricing as well as lowering the risk thereby contributing to the market allocation efficiency and allows better management of the balance sheets of firms and reducing the vulnerability of the firms to economic shocks, lowering risk management costs and creating the necessary conditions for.....

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