How Successful Is The Macroeconomic Framework Established By Emu? Answer By Focusing Specifically On Monetary Policy: Is The Ecb An Inflation Targeting Central Bank? Evaluate Its Performance In The First Ten Years Of Operation

1505 words - 7 pages

The European Monetary Union (EMU) was established as a formal objective in 1992 from the Treaty of Maastricht. In 1995 initial details of a union currency “the Euro” was announced and in 1998 the European Central Bank (ECB) was created and in 1999 the Euro underwent a 3 year transition introducing the Euro notes and coins. The purpose of this text is to analyse in detail EMU’s macroeconomic framework and performance and how this has evolved in the past 10 years. Firstly, I will look into the fiscal policy set out by the EMU however the bulk of the text will look into the monetary policy framework. Finally I will conclude by briefly trying to pin point the links between the macroeconomic ...view middle of the document...

I will now focus our attention to the second main macroeconomic framework; Monetary Policy. By joining the Eurozone, member states give up control of their monetary policy and all monetary policy decisions is taken up by the European Central Bank. The creation of the ECB was regarded as a beginning of a historic experiment. Initially 11 states joined the Eurozone expanding to what are currently 17 states. The ECB is an independent central bank and its main target is to achieve price stability across the Eurozone by having an inflation target of just below 2%. To achieve this is uses the nominal interest rates as its policy instrument. The ECB undertakes a 2 pillar strategy in helping it achieve its target of price stability. The first pillar is known as the Economic pillar, which makes use of Taylor rules to guide the ECB in making the correct interest rate decisions. This is based upon making use of the analysis done on forecasts of the output gap and deviation of inflation from the target. Unlike many independent central banks, the ECB also makes use of the monetary pillar. This uses a reference growth rate of a broad monetary aggregate. The ECB’s inflation target is a rate is just below 2%. Its reference for the growth rate of the money supply (the broad monetary aggregate, M3) is 4.5%. It is this 2 pillar strategy that sometimes may cast conflicting signals on the way the ECB operates and it raises the question whether the ECB is in fact an inflation targeting central bank.

Inflation targeting is strictly followed by the Bank of England and the central bank of Canada. The idea is that a quantitative target enables the general public to form expectations fairly easy and that people will behave according to these expectations. In the UK if inflation deviates by 1% from the target of 2%, then the governor of the Bank of England (Mervyn King) must write an open letter to the Chancellor explaining why this has occurred and what steps have been put in place to bring inflation back to its target. In comparison the ECB is not explicitly held responsible for deviations of the inflation target and there is no set range in which the inflation can vary from the target. Furthermore due to the 2 pillar strategy it is much harder for the ECB to communicate its goals and strategies, because there may be many conflicting signals in the way the ECB sets its interest rate. Therefore given the differences above it can be viewed that the ECB is far less accountable for inflation setting in comparison to its counterparts such as the Bank of England (BOE).

There are 2 well documented scenarios which show the usefulness of the monetary pillar. Charles Goodhart (2006) highlighted 2 episodes in which the monetary growth above the 4.5% reference rate. In the first case (2001-2003) the ECB did not show any reaction as it correctly analysed that the higher growth rate was a result of a temporary increase in money demand and not an inflationary...

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