EUROPEAN ECONOMICS:

EUROPEAN CENTRAL BANK

THE ECB
 Two dominating post – war models of Central Banking
Systems.
 Anglo – French Model:
 Objectives: Many and equally weighted. Price stability, low
unemployment, low inflation.
 Institutional Design: Politically dependent on Government
 German – Swiss Model:
 Objectives: Primary focus is given to price stability, although there
may be other, secondary, objectives.
 Institutional Design: High degree of political independence.
 However, what format should the ECB take?
 For reasons explained on next slide, it follows much in the
tradition of the latter (hence, can be seen as a successor to the
BB in many aspects).
THE ECB
 As stated in previous slides, there is a case for ‘locking in’ a country at a lower
inflation rate.
 If we use the German inflation rate (shown as CB1 on the next slide), then the
set up is Pareto Optimal  Germany is no better or worse off, and the other
country is better off.
 However, this ‘locking in’ can be done one of two ways:
 The other country joins the DM.
 Both countries join the Euro (which will require a new, central, bank).
 The first option was seen as politically unfeasible, so the second option was
taken up.
 However, the problem then becomes how we make it Pareto Optimal for both
countries.
 If the interest rate target is set too high (CB2), then Germany Loses (it will
be at point B rather than A).
 Therefore, it was always going to be the case that the ECB had to be similar to
that of the BB in order to prevent the Germans from losing out.
 In addition, the ECB was established as monetarism was at the height of it’s popularity
 strong emphasis on a ‘natural’ rate of unemployment, therefore focus efforts on
inflation.
 THE ECB
π LRPC R.FI π LRPC

R.FG
CB2
C C

CB1
A A

Unemployment Unemployment

Italy Germany
THE ECB
 The next problem we face is that of the what type of Central Bank it
will be.
 There are two dominant types of CB:
 WEIGHT CONSERVATIVE CB:
 Where the CB puts a higher weighting on low inflation than society
does:
 Vsoc = u2 + (π – π*)2
 VCB = u2 + β (π – π*)2
 TARGET CONSERVATIVE CB:
 Where the slope of the CB and Societies Reaction Functions are
EQUAL (suggesting the same degree of stabilisation in a shock), but the
CB’s R.F is at a lower level of inflation (Bliss Point at 0 inflation).
 Vsoc = u2 + (π – π*)2
 VTCB = (u – un)2 + (π – π*)2
 The next slide shows what happens to either system under an
adverse shock (which shifts the SRPC upwards).
THE ECB
π LRPC R.FSoc π LRPC

A
R.FSoc

R.FWCB
R.FTCB

USoc UCB U Un UCB = USoc U

Weight Conservative Target Conservative

THE ECB π LRPC
 Therefore, a Target Conservative CB is the First – Best solution
 the same degree of stabilisation as society desires, but at a
lower level of inflation.
R.FSymmetric
 In addition, the problem of deflation is curtailed by the ECB
having a clause that it won’t pursue an unemployment level
below Un.
 However, a major problem in practice is that it could lead to over
– conservatism. There is an incentive to reinterpret any rise in
unemployment as a shift in the LRPC (due to a rise in the
natural rate of unemployment) R.Factual
 Wrongly interpreting such a rise would lead to an unexpected rise
in inflation (as it is the SRPC that has shifted, not the LRPC).
 In practice, whilst the intention of the ECB is to be Target
Conservative, it actually resembles a Weight – Conservative
system.
R.Fasymmetric
 This can be seen by studying the differences in how it behaves in
a Symmetric and Asymmetric shock (shown on next slide).
 Asymmetric Shock: The net effect on unemployment could be 0,
so the ECB should do NOTHING.
 Symmetric Shock: The ECB should be involved in stabilising.
 Therefore, there are two reaction functions that a TCB would
chose between depending on the shock; the ECB’s RF falls in
between those two, much like a WCB.
 We can also conclude that – as shocks usually contain both a
symmetric and asymmetric component - the ECB stabilises less
than an individual country would desire  Can be shown by
calculating the desired interest rate via the Taylor rule and
U
comparing.
 THE ECB – ASYMMETRIC SHOCK
LEADING TO INACTION FOR A TCB (UI =
UD)
π LRPC π LRPC
R.F
R.F

Π*

Unemployment
UI Unemployment UD

Italy Germany
THE ECB
 How does the ECB achieve Price Stability?
 The ECB follows a ‘Twin Pillar’ strategy:
 Inflation Targeting – Long Run Target
 Money (M3) Targeting – Medium Run Target
 Note that the overall objective is Price Stability, but in the case of a demand side shock, output
stability can be achieved simultaneously – contractionary/expansionary monetary policies shift the
AD curve.
 The main focus of the ECB is on the level of M3, and this carries on from the BB being
Friedmanite in a similar fashion.
 However, there are NO EXPLICIT WEIGHTINGS on either pillar.
 To calculate the growth rate of money, use the QUANTITY THEORY OF MONEY:
 MV = PY
 Take logs + time derivatives: m’ = π + y’ – v’
 Where ‘m’ is the level of money, ‘v’ is the velocity of money, ‘p’ is price level and ‘y’ is
output.
 A problem with this approach is that v’ is highly volatile, hence m’ is as well.
 However, one cannot purely focus on inflation targeting because of the LUCAS
CRITIQUE and inability to detect BUBBLES.
 We must use some inflation targeting, however, because otherwise the repercussions are simply too
devastating and impractical to implement.
 Inflation is an ASYMMETRIC TARGET  2% according to the Harmonised Index of
Consumer Prices (HICP).
THE ECB
 Criticisms of the ECB Monetary Policy Strategy:
 No clear weighting of ‘pillars’.
 Velocity of money (and therefore growth rate of money) is highly volatile.
 The ECB is a goal – independent CB (it chooses it’s own targets), and there are
calls to make the ECB give an explicit lower bound.
 ECB wants inflation below ‘but close to’ 2% HICP.
 No lower bound suggests that the ECB would risk deflation and still consider it a
better outcome than post 2% inflation.
 ECB has utterly failed it’s ‘second pillar’ – i.e., controlling M3 growth,
however, it has broadly succeeded in controlling inflation.
 This suggests that the Monetarist assertion that Inflation is instigated by the money
supply fluctuations is less than tenable
 There have been calls for the ECB to adopt a more modern approach and use
current inflation as an ‘intermediate target’ – thus replacing M3 growth.
 In doing this, the ECB would include ALL relevant information on what
future inflation may be – currently, by focusing on M3, it excludes much of
that information.
THE ECB
 Independence and Accountability
 It is essential that the ECB is accountable to a higher power in order to prevent it from not
fulfilling it’s mandate or making mistakes (such as not stabilising output where it is
possible to without compromising price stability).
 By granting greater degrees of Independence there is a need to extract a greater degree of
accountability.
 This is shown Graphically on next slide (taken from de Grauwe).
 The ECB has the following features:
 Independence:
 Elections outside the political cycle – once every 7 years.
 Goal Independent - sets it’s own targets.
 Politicians do not make the decisions – Technocrats do; although votes are weighted by country to
prevent a small country taking hostage a group of larger ones.
 Accountability:
 Uses both FORMAL (sacking etc.) and INFORMAL (transparency) methods of accountability;
latter was pioneered by the BB.
 Formally accountable to European Parliament, and the National CB (which it delegates
responsibility to on occasion) is accountable to it’s respective national parliament.
 Informally, it is highly transparent  Provides a stream of real time information to inform media
+ markets/
 HOWEVER, changing the statutes of the ECB is incredibly difficult due to the need for unanimity
amongst ALL EU member states, therefore it is questionable whether it is really formally
accountable.
THE ECB
Independence

ECB Optimal
Combination

Bundesbank

Federal Reserve

Accountability
Source: de Grauwe (2008)