Feb 24 2004

Lesson 6

By

John Kennes

International Monetary Economics

Feb 24 2004

The European Monetary Union

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The launch of the euro represents the end of a long process

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• 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

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

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Inflation criteria: A fear of allowing in unrepentant inflation-prone countries

0.00

5.00

10.00

1991 1992 1993 1994 1995 1996 1997 1998

France Italy

Spain Germany

Belgium PortugalGreece average of three lowest + 1.5%

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• 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

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• Need to convince the exchange market. Need to show a non-superficial conversion to price stability.

• Membership demonstrates the country’s 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

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• 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

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• 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

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Budget Deficit and debt criteria: in 1997

Maastricht fiscal criteria 1997

0

20

40

60

80

100

120

-3 -2 -1 0 1 2 3 4 5

Deficit (% GDP)

Pu

bli

c D

eb

t (%

GD

P)

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• 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

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The System

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• 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?

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• The Maastricht Treaty’s 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)

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• 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)

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• Leaves room for interpretation– Where below 2 per cent?– What is the medium term?

Objectives (2) comment

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• 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)

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• 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)

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EONIA & Co.

0

1

2

3

4

5

6

7

Jan.99 Jul.99 Jan.00 Jul.00 Jan.01 Jul.01 Jan.02 Jul.02 Jan.03 Jul.03

EONIADeposit facilityMarginal lending facilityMain refinancing

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• The monthly Eurosystem’s 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

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• 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

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• 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

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A Reasonable Fit: Suppose ECB sets interest rates by the Taylor Rule

Inflation

0

0.5

1

1.5

2

2.5

3

3.5

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003

Output gap

-2.5-2

-1.5-1

-0.50

0.51

1.52

2.5

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003

0

1

2

3

4

5

6

7

8

Q1-1999 Q1-2000 Q1-2001 Q1-2002 Q1-2003

EONIA Taylor rule

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• 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?

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• 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

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• 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 Fed’s independence

Redressing the Democratic Deficit

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• The Eurosystem must report to the EU parliament

• The Eurosystem’s President must appear before the EU Parliament when requested, and do so every quarter

• But the EU Parliment cannot change the Eurosystem’s independence and has limited public visibility

The Eurosystem Weak Accountability

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• A difficult period

– An oil shock in 2000– A worldwide slowdown– September 11– The stockmarket crash 2002– Afghanstan, Iraq

The Record So Far

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Inflation: Missing the Objective a Little

0.5

1

1.5

2

2.5

3

3.5

Jan.99 Jan.00 Jan.01 Jan.02 Jan.03

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The Euro: Too Weak First, Then too Strong?

The euro/dollar exchange rate

0.8

0.9

1

1.1

1.2

Jan.99 Jul.99 Jan.00 Jul.00 Jan.01 Jul.01 Jan.02 Jul.02 Jan.03 Jul.03

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But No Seriously Asymmetric Shocks

Inflation

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

1991 1993 1995 1997 1999 2001 2003

Average Min Max

GDP growth

-5.0

0.0

5.0

10.0

15.0

20.0

1991 1993 1995 1997 1999 2001 2003

Average Min Max

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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

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