COMMON MONETARY POLICY

Institutions and objective

A. ORGANISATION.

◼ How to decide on a common monetary policy for 19 countries that share the euro.

◼ ECB part of the EUROSYSTEM = new ECB +19 NCBs (National Central Banks of countries without a national
currency, part of the eurozone, eg. Banco de España).

◼ The NCBs still exist, but not issuing their own money independently any more. Like “windows” of the ECB in each
country.

Executive Board

◼ 6 members (including president and vice-president of the ECB).

◼ Appointed by European Council (heads of government only of the eurozone) by qualified majority.

◼ Do not represent a particular country.

◼ Usually from large countries or with the support of large countries.

◼ Long mandate, 8 years, non renewable (to guarantee their independence).

◼ Conduct of the day-to-day business with staff of the ECB, preparation of meetings (economic analysis) of the
Governing Council
Governing Council (THE MOST IMPORTANT ONE)

◼ 6 members of the Executive Board + 19 governors of National Central Banks (NCBs) in the eurozone.

◼ One important meeting per month to adopt MONETARY POLICY DECISIONS (ON INTEREST RATES).

◼ One person, one vote

◼ Centralized decision-making on common monetary policy (MAIN TOOL CONTROL OF ONE INTEREST RATE, the
REPO RATE for MAIN REFINANCING OPERATIONS).

◼ It is the interest rate at which ECB lends to commercial banks. Guides all other interest rates, when commercial
banks lend to firms and families. Banks pass the increase (or decrease) to their costumers, affecting aggregate
Consumption and Investment.

Many different interest rates in the economy: MORTGAGES CONSUMPTION… BUT THEY MOVE NORMALLY IN A
HIGHLY CORRELATED WAY AND THE INTEREST RATE CONTROLLED BY THE CENTRAL BANK IS LEADING AND GUIDING
ALL THE OTHERS

GENERAL COUNCIL

◼ European System of Central Banks (ESCB): ECB + 27 NCBs of all European Union countries (not only those in the
eurozone).

◼ GENERAL COUNCIL

◼ President and vice-president of the ECB + 27 governors of NCBs.

◼ Meets only once every three months (quarterly).

◼ Coordination, information between INs and OUTs. And checks progress in fulfilling conditions to enter the
eurozone (Maastricht or convergence conditions on inflation, public deficits…).
B. OBJECTIVE.

◼ PRIMARY OBJECTIVE PRICE STABILITY (in Treaty of Maastricht).

◼ Defined by the ECB initially as an annual rate of inflation below 2%, measured using the Harmonized Index of
Consumer Prices (HICP).

◼ “Harmonized” methodology in every country, so that data can be easily compared and aggregated.

◼ The only important rate for the ECB is the RATE OF INFLATION OF THE EUROZONE AS A WHOLE (different
national inflation rates are possible behind the aggregate)

◼ ECB strong mandate against inflation (in comparison with other countries or in historical perspective).

◼ To preserve purchasing power of wages, pensions…

◼ 8-5-2003 BCE small reform in the objective: inflation rate below BUT CLOSE TO 2%.

◼ 8-7-2021 new small reform: aiming for 2% inflation in a SYMMETRIC way. Negative and positive deviations
from the target are equally undesirable.

◼ Deflation (negative inflation) is also a problem

◼ And what about OUTPUT and EMPLOYMENT? Output stabilization is not forbidden, but only possible
WITHOUT PREJUDICE TO PRICE STABILITY.

◼ ASSET PRICES (shares, houses) not part of the HCPI (only includes consumption goods and services).
Therefore, past BUBBLES where not considered a problem until too late.
STRATEGY

◼ CRITERIA stablished TO set interest rate in order to fight inflation (to ACHIEVE THE OBJECTIVE, THE TARGET).

◼ Two-pillar approach: - But in practice only first pillar important: ECONOMIC ANALYSIS

◼ Based on the THEORY OF INFLATION in the SHORT RUN

Economic Analysis

THEORY OF INFLATION IN THE SHORT RUN: any shocks to Aggregate Demand or Aggregate Supply affects Prices.
Analysis of broad range of indicators signaling inflationary pressures in the short run:

◼ Aggregate Demand: data related to C, I, G, X…

◼ Aggregate Supply: wages, prices of raw

SHOCKS IN AGGREGATE DEMAND:

◼ INVESTMENT (and CONSUMPTION) are related to the interest rate, because often financed by LOANS.

◼ How much INVESTMENT decided COMPARING:

- Expected rate of return on investment projects (given at any moment in time, but with high volatility over time)

- with INTEREST RATE on the loan used to finance the investments.

- If lower interest rate, more Investment (more projects with a rate of return higher than the interest rate).

- MONETARY POLICY can help to STABILIZE the business CYCLE. NOW COMMON = FOR THE EUROZONE AS A
WHOLE.

INFLATION due to shocks in DEMAND:

◼ Before 2000 and before 2007: Investment and Consumption growing strongly (higher prices of shares and
houses)

◼ Output and PRICES grow (= inflation)

◼ MP contractive, rising repo rate from ECB to banks

◼ Banks rise their interest rates to costumers

◼ Less C and I

◼ AD had moved to the right and now (thanks to MP) partially back to the left, fighting inflation.
If DEMAND DECREASES:

◼ No danger of inflation; problem less output (and unemployment).

◼ After 2000, after 2007 and in 2020 (COVID) when C and I decreasing

◼ MP expansive, lower repo rate from ECB to banks

◼ Lower interest rates from banks to costumers

◼ More C and I

◼ AD had gone to the left and now partially back to the right (thanks to MP), fighting recession

COUNTERCYCLICAL MONETARY POLICY of ECB: higher interest rate during expansions, lower interest rate during
recessions.

SHOCKS IN AGGREGATE SUPPLY:

INFLATION due to Supply shocks: increase in COSTS of PRODUCTION

◼ Price of oil increases strongly, or wages (1970s) OR NOW in 2022

◼ Inflation and output behave both badly (STAGFLATION), Aggregate Supply moves upwards.

◼ This kind of shock is more complicated for MP. Must choose which problem to fight.

◼ If inflation (as the legal mandate requires): higher interest, Demand to the left. More recession.

◼ Problem: what has moved initially is Agrregate Supply, and Monetary Policy can only move Aggregate
Demand.

Now supply shock in eurozone:

◼ Inflation 10.7% (October 2022).

◼ Due mainly to prices of energy (gas and oil), invasion of Ukraine.

◼ And (since 2021) supply bottlenecks due to COVID.

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◼ NOT SO EASY in the real world as it looks in the diagrams of AD-AS.

◼ ECB needs to get a picture IN REAL TIME of how the movements in many variables are affecting AD-AS and
inflation.

◼ And there are LAGS in the monetary transmission mechanism; a year a half can be needed since interest rates
rise until all effects (on C, I…) develop.

◼ That´s why sometimes inflation can be higher than the target of 2%. In that case, the ECB´s compromise is to
take more measures until back under control.

Stability of prices since creation of euro achieved (so far):

◼ Green line: general level of prices if 2% annually.

◼ Blue line: general level of prices in eurozone.

◼ First years on target.

◼ After previous crisis, too little inflation.

◼ Some room to “catch up”

EXTRAORDINARY MONETARY POLICY MEASURES AGAINST THE PANDEMIC

◼ Several WAVES of the pandemic in the Eurozone.

◼ Economic crisis LONGER than initially expected.

◼ DEEPER than the previous crisis of 2008.

◼ Specially SERVICES more affected (tourism, bars, restaurants, travel…).

◼ But the Eurozone´s GDP has recovered.

◼ After the strong initial decline

◼ At first, deflationary consequences, due to strong negative shock to Aggregate Demand.

◼ Negative inflation, too far from the objective (of 2%).

◼ Ordinary monetary policy (zero repo interest rate already) not enough. Extraordinary crisis.

“QUANTITATIVE EASING” = ASSET PURCHASES

◼ Already previous measure in place (since 2015): APP (Asset Purchase Programme), with PSPP (Public Sector
Purchase Programme, of public debt) as the main component.

◼ Article 123.3 of Treaty forbids the ECB to monetise public deficits, to buy directly debt issued by a national
government.

◼ To avoid this legal constraint, ECB only buys national public debts in the secondary market (not to the
governments directly, but to previous buyers).

◼ The economic effects are similar: increase in demand for those bonds, higher prices, lower interest rates.

◼ Helps governments to issue new public debt, to finance higher public expenditure, at low interest rates.
Favourable financing conditions for national Fiscal Policy.

◼ More aggressive policy than the ordinary one, because ECB helping governments not through commercial
banks. To sustain G, a component of Aggregate Demand (in national hands)

◼ To avoid favouring an individual country, PSPP (main component of APP) buys national public debt:

 According to the share of each country in the capital of the ECB = according to the relative size of GDP in
eurozone (12% Spain). Helping all…

 Not more than 33% of the total stock of national public debt. To avoid too much concentration.

◼ When the pandemic hit, in March 2020, this old APP (buying 20 billion euros per month) was kept and
reinforced with 120 billion more until the end of 2020.

And additionally a new programme was created (18th March 2020): the PEPP (Pandemic Emergency Purchase
Programme):

 Initially 750 billion until end of 2020. Later 600 billion and 500 billion more, until march 2022 = 1.85
trillion. HUGE!!!

 NO LIMITS in terms of countries or percentage of total stock. Can concentrate help on worse hit countries
(Italy, Spain…). More flexible.
Year 2022: end of the expansive monetary policy

The ECB has bought (in the secondary market) almost all of the increase in Spanish public debt due to COVID

Decreasing strongly the interest rate paid on Spanish (and other) public debt

◼ This has made possible to increase national public spending (G), to implement expansionary national fiscal policies

◼ Financing the huge public deficits

◼ The ECB buying huge amounts of public debt at very low interest rates

The eurozone´s GDP has recovered, as one of the main reasons, thanks to the increase in G made posible by the
extraordinary MP
FISCAL POLICY
THE STABILITY PACT

ECONOMIC JUSTIFICATION of the Pact:

◼ FISCAL POLICIES not common, they stay in NATIONAL HANDS.

◼ The goal is to AVOID that irresponsible national fiscal policies, EXCESSIVE DEFICITS, INTERFERE WITH THE
COMMON MONETARY POLICY of the eurozone (ECB) or requires help from other governments of the eurozone.

◼ How? LIMITING NATIONAL FREEDOM in the use of Fiscal Policy, THROUGH THE STABILITY PACT.

◼ But Fiscal Policy BECOMES EVEN MORE IMPORTANT THAN BEFORE for eurozone´s countries (= no national
Monetary Policy) as main tool to manage national Aggregate Demand when problems (recession, inflation) are
affecting only one country.

◼ RESTRICTIONS, therefore, SHOULD BE FLEXIBLE enough to let Fiscal Policy play this role.

◼ SOURCE OF PROBLEMS and impopularity for the EU: Fiscal Policy is more important than ever (no national
Monetary Policy) but European rules set some restrictions (for euro members).

Some possible INTERFERENCES of national Fiscal Policies on common MP:

if “excessive” NATIONAL public deficits and public debt (eg. Greece):

◼ If high debt, ECB worried when interest rates have to be raised, because interest payments will be increased,
worsening the national budgetary problems.

◼ If DEBT CRISES, G = T suddenly. Social G collapses… Common ECB (and other national governments of the
eurozone) under pressure to help.

◼ If BANKING CRISES (comercial banks owners of large amounts of national public debt) common ECB (and other
national governments of the eurozone) under pressure to help

◼ Great Recession (after 2008) has shown that these dangers were real.

◼ It makes sense, therefore, to TRY TO PREVENT them. THAT IS THE MEANING OF THE PACT.

◼ The STABILITY PACT goes to the root of those problems: “EXCESSIVE PUBLIC DEFICITS”.

◼ BUT also limits the use of national fiscal policy when most needed (as could be seen after the crisis of 2008).
Lesson learned for the COVID CRISIS: European fiscal rules TEMPORARILY SUSPENDED (eg. public deficit of Spain in
2020 higher than 11% of GDP)
Stability Pact

◼ REFERENCE VALUE 3% of GDP for the sum of the deficits of ALL PUBLIC ADMINISTRATIONS
(central+regional+local), same as the Maastricht criteria to enter the eurozone. If larger, EXCESSIVE DEFICIT.

◼ EXCEPTIONS: if exceptional recession (defined as anual reduction in real GDP), national public deficit larger than
3% allowed, to let Fiscal Policy (automatic stabilizers) work.

◼ FINES, SANCTIONS:

◼ Fixed component: 0.2% of GDP.

◼ Variable component: 0.1% of GDP for each point in excess of the reference value of 3%.

◼ Maximum ammount set at 0.5% (if deficit of 6% or larger)

◼ Very tough at first sight (not much flexibility):

◼ In the past there were many cases of deficits larger than 3% when not decline of real GDP .

◼ Large sanctions (in million euros), eg. Spain 0.5% GDP = around 6 000 million euros.

◼ But flexibility due to LONG TIME LIMITS.

◼ Only after 5 more years without correcting the excessive deficit a FINE possible.

◼ Even then, flexibility due to SANCTION NOT AUTHOMATIC

◼ Fine can be forgiven by Council (Eurogroup) by qualified majority.

◼ Political decisión: strategic considerations… will play a role

Public deficits1999-2010 (% GDP). Germany and France were the first to risk a fine.

FIRST REFORM of the STABILITY PACT (2005) to make it even more flexible:

◼ ANY decrease in real GDP, EXCEPTION.

◼ TIME LIMIT extended from 3 to 5 years before fine

◼ Afterwards, the Pact failed completely. Not able to avoid the problems that tried to prevent.

◼ After the CRISIS of 2008, many countries with EXCESSIVE DEFICITS and increasing public debt, although real GDP
growing. Even some public debt crises.

◼ BUT SANCTIONS HAVE NEVER BEEN APPLIED. Only used to negotiate and put pressure to reduce the deficit (in
middle of the crisis). Leading to anti EU feelings

COVID CRISIS:

Some LESSONS LEARNED from previous crisis:

- This time FISCAL RULES OF STABILITY PACT TEMPORARILY SUSPENDED, to allow larger public deficits and let
national Fiscal Policies work without interfering.

- And ECB helping to finance those deficits (as we saw, governments issuing national public debt at very low interest
rate, thanks to the ECB´s extraordinary policies).

- Plus transfers from NGEU

REFORMS AFTER THE CRISIS (of 2008)

EUROPEAN SEMESTER (to better coordinate and PREVENT):

Commission SUPERVISES NATIONAL FISCAL POLICIES BEFORE THE BUDGETS GO FOR APPROVAL TO THE NATIONAL
PARLIAMENTS. (Introduced in January 2011)

-Eurozone´s countries present their STABILITY PROGRAMMES, explaining their fiscal plans for the next 3 years.

-Commission undertakes analysis of each country´s plan. Provides RECOMMENDATIONS.

- SUPERVISION and evaluation to PREVENT problems (excessive deficits…) BEFORE they appear

MORE REFORMS TO IMPROVE THE STABILITY PACT:

1º) “SIX- PACK” (since 2011):

Improves the QUALITY of the fiscal SUPERVISION Takes into account other MACROECONOMIC IMBALANCES (apart
from the public deficit

IMPROVES information provided by NATIONAL FISCAL FRAMEWORKS:

-Better data (statistics, accounting…). No more tricks!

- Better FORECASTS. Create INDEPENDENT national institutions to evaluate them (eg. AIReF in Spain)

New procedure to identify and correct (recommendations…)

EXCESSIVE MACROECONOMIC IMBALANCES, not only the public deficit

Taking also into account imbalances in the PRIVATE sector (eg. house prices) (They are announcing future crises and
future budget deficits. PREVENT)

“TWO –PACK” (since 2011)

If a country has received FINANCIAL ASSISTANCE (rescue, bail out) or has an EXCESSIVE deficit procedure:

-ADDITIONAL SUPERVISION (more frequency, more detail).

-Also additional RECOMMENDATIONS (corrective actions, structural reforms) and warnings

FISCAL COMPACT (since 2013):

It is an INTERGOVERNMENTAL TREATY

-NATIONAL BUDGETS MUST BE IN BALANCE (O SURPLUS) IN NORMAL TIMES. LEAVE ROOM FOR INTERVENTION
AGAINST CRISIS, FOR FISCAL STABILIZERS TO WORK.

-NEW: STRUCTURAL DEFICIT (removing factors due to the business cycle; it has to be calculated, assumptions) at
most 0.5% of GDP

Countries have to TRANSPOSE INTO THEIR NATIONAL LEGAL ORDER THE PROVISIONS IN THE FISCAL COMPACT, so
that they are permanent and more credible; if possible in the CONSTITUTION, at the highest legal level.

Ej. Reform art. 135 Spanish Constitution and “Ley de Estabilidad Presupuestaria” that develops article 135

EUROPEAN STABILITY MECHANISM (ESM, since 2012):

VERY IMPORTANT: ONLY REFORM TO HELP COUNTRIES WITH PROBLEMS, INSTEAD OF BETTER CONTROLING THEM.

To provide help (bail out) to COUNTRIES of the eurozone suffering from a PUBLIC DEBT CRISIS, to avoid default.

Coming from other governments of the eurozone, but in an organized way, permanent (not like first loan to Greece).
Avoids more pressure on the ECB to help. Rescue can come from other governments through the ESM.

In the form of LOANS. Financial assistance.

Government in difficulty (of the eurozone) ASKS for FINANCIAL ASSISTANCE (help, loans) from the ESM. Apply for a
bail out.

EVALUATED by Commission, ECB and IMF (“Troika”) to see if feasible, how much, which conditions…

CONDITIONALITY, Memorandum of Understanging (MoU) outlining a program of reforms and fiscal consolidation, to
restore public debt sustainability.

Rescued before ESM: Ireland, Portugal, Greece. After ESM: Spain, Cyprus

Maximum lending capacity 700.000 mill. euros. Large.

Only 80.000 mill. euros paid-in capital (by eurozone goverments in proportion to their GDP).

The remaining 620.000 mill. euros, if needed, will be raised in capital markets, issuing debt (ESM bonds) JOINTLY
GUARANTEED BY THE MEMBER STATES. Common European debt.

Able to borrow money cheaply. Then, loaned to the country rescued, that cannot raise money in capital markets at
reasonable interest rates (or at all)

BOARD OF GOVERNORS decides, ministers of Finance of the eurozone.

Number of votes according to part of CAPITAL, proportional to the size of their economies (GDP).

Decisions of rescue by UNANIMITY

future REFORMS are needed.

BOARD OF GOVERNORS NOT to decide by UNANIMITY.

Provide help (loans) also to countries that are not in such extreme difficulty and with less conditionality. RECENTLY:
PANDEMIC CRISIS SUPPORT LINE. Providing loans, amount up to 2% of GDP (around 22.000 mill. euros in the case of
Spain), maturity 10 years, interest rate around 0.1%; main condition to use it for healthcare expenditure related to
the pandemic.

But countries did not ask them, due to the stigma attached to using the ESM in the previous crisis
NGEU: MEASURES OF THE EU-27 AGAINST COVID

Severe lockdowns had huge economic effects:

• SUPPLY shock: bottlenecks in imports…

• And DEMAND shock: closed shops, strong decreases in Consumption and Investment…

• IN THE SHORT RUN, THE DEMAND SHOCK IS STRONGER: low (even negative) inflation.

• It is necessary to stimulate Aggregate Demand through an EXPANSIVE FISCAL POLICY (more public expenditure,
public deficits, public debt)

But in the EU Fiscal Policy is in national hands and the countries worse hit by the crisis had less fiscal margin: already
large public deficits and debt when it began

THE ROLE OF THE EUROPEAN UNION

To help NATIONAL FISCAL POLICIES (not common), specially in the worse hit countries:

Next Generation EU RECOVERY PLAN (750 billion euros) that includes a part in LOANS (with very favourable
conditions) AND ANOTHER IN GRANTS (transfers, “gifts”).

To this should be added the extraordinary Monetary Policy of the ECB (ONLY FOR THE EUROZONE) already explained
(it has been the most important measure taken against the COVID economic crisis from the European Union, due to
its size and speed

HOW THE FUNDS WILL BE RAISED

• One of the more revolutionary features of the NGEU.

• ISSUING DEBT OF THE EUROPEAN COMMISSION = COMMON EUROPEAN DEBT (guaranteed by all members of the
EU-27, using the common “own resurces”, therefore each one aproximately in proportion to the size of the national
GDP).

• For many years there had been a debate on Eurobonds, the need to create a common European debt. It seemed
impossible, with countries like Germany against sharing risks.

• 1st RED LINE CROSSED. Although, in theory, only this time, EXTRAORDINARY

• Selling bonds IN THE CAPITAL MARKETS, 750 BILLION in 6 years, until 2026.

• Thanks to safety (AAA rating), very low interest rates, a bit higher than German debt, but lower than countries with
problems by themselves. Eg. Interest rate of the 1st issue of 10-year bonds: 0.086%. Large demand of safe assets,
needed by pension funds, insurance companies...

• TO BE REPAID in 2028-2058 (30 years). In principle, it will be completely repaid and it will disappear.

• There was some common European debt before (eg. European Stability Mechanism/ESM…) but not in this amount
or for these purposes.
DISTRIBUTION AMONG COUNTRIES

• A bit less than half (360 billion) in LOANS with very favourable conditions (low interest rate, long maturity).

• A bit more than half (390 billion) in GRANTS (transfers not to be returned, “gifts”).

• Distributed according to criteria that favour THE WEAKEST COUNTRIES.

• 2nd RED LINE CROSSED, TRANSFERS: “frugal countries”, net contributors to the common budget, historically
opposed to them.

• TOTAL AMOUNT 750 billion (390 grants + 360 loans), around 6% of the EU-27´s GDP.

• CRITERIA FOR THE DISTRIBUTION among countries:

- Population.

- GDP per capita.

- Past unemployment (2015-2019).

• SPAIN ONE OF THE MOST FAVOURED: around 140 billion (almost 20% of the whole NGEU), around 12% of the
Spanish GDP

HOW THE FUNDS WILL BE USED

• To be spent IN 6 YEARS (2021-2026).

• To finance expenditure proposed in the NATIONAL RECOVERY AND RESILIENCE PLAN prepared by each country.
The European Commission supervises them (has to approve them and see if they are really implemented).

• Promoting GREEN (minimum 37% of total) AND DIGITAL (minimum 20%) expenditure, and REFORMS, to achieve a
sustainable recovery and increase growth potential.

• To absorb such large funds, to design and implement enough efficient projects SO FAST difficult. Administrative
problems.

• The PAYMENTS will be disbursed IN INSTALMENTS, when targets set in the Plans are met
HOW THE DEBT WILL BE REPAID:

• The debt issued to finance the part of NGEU given as LOANS (360 billion) will be repaid by the beneficiary Member
States (when they give their loans back).

• The debt issued to finance the part of NGEU given as GRANTS (390 billion) will be repaid using the “OWN
RESOURCES” of the common European budget. They will be increased accordingly.

• A new way has been chosen to increase them : CREATING NEW “own resources” with the nature of COMMON
EUROPEAN TAXES (3rd RED LINE that is crossed). Still the details are not fully clear

LIMITATIONS of the NGEU:

• At first sight looks huge, 750 billion (6% of the EU´s GDP).

• But it is spread over 6 years (2021-2026) = around 1% of the EU´s GDP per year.

• Stronger support for the more vulnerable countries, SPAIN receives 140 billion (12% of Spain´s GDP), 2% of Spain´s
GDP per year (2021-2026):

- Around half of them in LOANS (1% of GDP per year) to be repaid in the future.

- The other half in GRANTS (1% of GDP per year), not to be given back. But Spain will have to contribute part
of the “own resources” (around 10% of the total) to repay the debt used to finance the grants.

- As a consequence, the NET GRANT (the net transfer of resources) is only around 0.5% of Spain´s GDP
annually during 6 years (around 6.000 million euros per year). Not so much. Spain´s public deficit was 11% of
GDP only in 2020

CONCLUSIONS:

• 1st red line crossed : to issue COMMON EUROPEAN DEBT.

• 2nd red line crossed: net TRANSFER of resources to more vulnerable countries, due to GRANTS.

• 3rd red line crossed: increase of “own resources” creating new EUROPEAN TAXES.

• Still NOT ENOUGH: NGEU is NOT PERMANENT, only for this emergency, EXTRAORDINARY.

• The possibility of a PERMANENT facility, of repeating this experience, WILL DEPEND on how well the NGEU works
(no corruption, selection of good projects, efficient implementation…).