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The European Central Bank and Price Stability Essay


Introduction

The European Central Bank (ECB) functions as the mainstream financial institution for the entire European Union (EU) members who use the Euro currency. The institution establishes an array of measures that seek to foster price stability in the Euro region, thus enhancing the currency’s purchasing power (Smets, 2014). Besides stabilising the price of the Euro, the ECB also offers banking supervision in the EU through the Single Supervisory Mechanism (Borio & Disyatat, 2010). Therefore, the ECB is a crucial institution in the EU since it develops and implements monetary policies that seek to improve the value of the Euro while at the same time enhancing price stability. The process of fostering price stability requires the ECB to engage in monetary policy actions that range from the definition of the financial guidelines to the promotion of the efficient operations of payment systems (de Haan & Kooi, 2000). Additionally, the ECB applies strategies that aim to realise the primary objective of maintaining price stability in the Euro region. In this respect, this paper evaluates the actions of the ECB in the conduct of monetary policies before describing the key strategies and tools applied to foster the stability of the Euro currency.

Actions of the ECB in the Conduct of Monetary Policy

The ECB undertakes several actions that facilitate the attainment of the institution’s primary objective. The notable ECB’s actions that are directed towards the conduct of the monetary policy include the definition and execution of the union’s financial guidelines. The ECB acts in ways that focus on improving the efficiency of the payment systems operations in the Euro area. Moreover, the Single Supervisory Mechanism (SSM) allows the ECB to supervise credit institutions situated in the 19 member states (European Central Bank, 2017). In this light, the realisation of the institution’s primary objectives through the outlined actions will go a long way in fostering the socio-economic and political development of the EU. Therefore, evaluating the actions of the ECB in its conduct of the monetary policy is relevant.

The ECB is mandated with the responsibility of defining and implementing the monetary guidelines that apply to the Eurozone. Particularly, the body underlines the need for national central banks to maintain deflation and inflation levels below 2% (Szczerbowicz, 2015). The effective management of inflation and deflation is identified as important in fostering price stability.

The ECB conducts foreign exchange operations that seek to stabilise the Euro. In particular, the institution undertakes foreign exchange swaps that allow it to buy or sell the Euro currency against other monies such as the United States (US) dollar (Dieckmann & Plank, 2011). It sells or buys the currency after a specified period. The approach implies that the Euro attains stability in the short and long-term by constantly trading against other currencies in the foreign exchange market.

The ECB’s management of foreign reserves ensures its acquisition of adequate liquidity to undertake foreign exchange activities if required. Besides offering liquidity, the management of foreign reserves fosters the security and returns of foreign exchange operations conducted by the ECB. The foreign reserves portfolio of the ECB is comprised of currencies such as the US dollars and the Chinese renminbi, as well precious materials, for instance, gold.

The Main Strategies and Tools Applied to Stabilise the Euro Currency

According to Panico and Purificato (2013), the ECB applies specific strategies to facilitate the stabilisation of the Euro price in the EU. The monetary policy strategies offer a comprehensive structure that facilitates the making of decisions regarding the application of short-term interest rates (Wright, 2012). In this light, the strategies employed by the ECB mainly target the regulation of interest rates to safeguard the Euro from price volatility. In facilitating the implementation of the ECB monetary policy strategies, the institution incorporates the art of quantitatively defining price stability and analysing price stability risks through a two-pillar method.

Defining Price Elasticity Quantitatively

The initial component of the monetary policy strategies established by the ECB focuses on defining price elasticity quantitatively (Giannone, Lenza, Pill, & Reichlin, 2012). The quantitative definition of price elasticity creates a clear perception of the desired value of the Euro amid financial waves in the global currency market. In particular, the Governing Council of the ECB defines price stability as the year-on-year upsurge of less than 2% of the Harmonised Index of Consumer Prices (HICP) in the Euro region.

The price elasticity definition facilitated by ECB in the Euro area fosters the transparency of the monetary policy it implements in the various member states. Additionally, the price stability definition offers the European citizens a perfect and quantifiable yardstick to gauge the accountability of the ECB (European Central Bank, 2017). The definition of the price along quantitative lines guides the public in the creation of expectations about the future price developments (Criste & Lupu, 2014). In this respect, the ECB needs to act in the best interest of the European citizens, thus spearheading the realisation of growth and development in the Euro area.

The maintenance of 2% inflation rates is adequate to denote the benefits of fostering price stability in the EU. Additionally, the quantitative figure offers a reasonable margin to mitigate deflation risks (Szczerbowicz, 2015). The integration of a safety margin against deflation goes a long way in ensuring the reasonable cutting of interest rates in the Euro area. Notably, in a deflation surrounding, it is difficult to apply the interest rate mechanism in implementing the monetary policy. The sufficient margin also ensures that every country in the EU can structurally cope with the considerably low inflation or deflation rates (Wright, 2012). Therefore, the margin provided by the ECB seeks to avoid straining the citizens of the various EU countries to achieve the desired currency value.

Importantly, the ECB encourages the medium term maintenance of price stability (Blot, Creel, Hubert, Labondance, & Saraceno, 2015). By so doing, the ECB plays an integral role in maintaining inflation rates below 2% in the medium term. The unceasing maintenance of a HICP of below 2% in the medium term also improves the purchasing power of the Euro currency in the short and long-term (Cour-Thimann & Winkler, 2012). Therefore, employing monetary policy strategies that incorporate the quantitative definition of price stability is crucial since all member states in the EU gain awareness regarding the recommended medium-term currency value.

The medium-term orientation of ECB provides the institution with the flexibility to foster effective response to the economic shocks that may arise. Therefore, the flexibility offers the institution the prompt response to issues that may influence the price of the Euro significantly. The medium-term approach allows the ECB to take note of the output fluctuations that affect the realisation of price stability (Subbarao, 2012). As a result, the medium-term orientation of maintaining price stability seeks to protect the monetary policy from the unpredictability of economic shocks.

The Two-Pillar Approach

The analysis of economic developments in a particular country or region is crucial in facilitating the adoption of an effective monetary policy (European Central Bank, 2017). In this concern, the two-pillar strategy incorporates an analytical approach that involves the monetary and economic analysis. Importantly, the two pillars allow the Governing Council to evaluate the overall jeopardy of price stability and the deliberations of the monetary policy.

The economic analysis concentrates on the measurement of the short-to-medium-term influencers of price changes. Thus, the ECB pays attention to the real activity, as well as financial situations, in the Eurozone economy (De Santis, Favero, & Roffia, 2013). In this view, it is important for the ECB to take into account the demand and supply forces that trigger price developments in the region. Therefore, there is a need for the ECB to constantly review the dynamic aspects of the regional economy.

Particularly, the ECB conducts a review of the overall output development to gauge its impact on the value of the currency. Besides, the institution conducts its economic analysis by reviewing the demand and labour market circumstances. Additionally, the economic analysis requires the ECB to conduct a review of a wide array of price and cost indicators put in place in the Euro area. Moreover, the body conducts economic analysis by undertaking a balance of payments review, as well as the fiscal policy applied in the region (Gambacorta, Hofmann, & Peersman, 2014). The reviews facilitate the creation of macroeconomic forecasts that denote the future performance of the currency.

On the other hand, the monetary analysis embraced by the ECB captures the long-term perspective of price stability in the Euro region (European Central Bank, 2017). In this case, the second pillar facilitates the understanding of the long-term money and price association. Important to note, the monetary analysis takes over from the short-to-medium-term analysis conducted through the economic breakdown. As such, the monetary analysis focuses on the medium and long-term assessment of financial trends.

The ECB assesses the effects of future inflation, as well as economic growth, by conducting an in-depth analysis of monetary and credit changes in the Eurozone (Nautz & Scharff, 2012). The facilitation of the monetary analysis prompts the ECB to integrate various instruments and tools to enforce price stability in the region (De Santis et al., 2013). For instance, the ECB incorporates monetary aggregates as an instrument for streamlining the process of financial analysis. Therefore, it is relevant to identify and briefly explain the tools and instruments applied by the ECB to facilitate the operations in the Euro area.

Open Market Operations

The application of the open market operations tool is common in facilitating the realisation of price stability. The tool plays a critical role in the management of the liquidity situation in the market besides signalling the ECB about the position of the monetary policy (Eser & Schwaab, 2016). The ECB may wish to conduct open market operations through four notable approaches. First, it may apply main refinancing operations (MROs) regularly to facilitate the maintenance of banks’ liquidity in the Eurozone. Second, the Euro system can apply long-term refinancing operations (LTROs) to constantly offer the banking system with long-term liquidity. Third, the integration of fine-tuning operations is also a way of managing the unanticipated liquidity fluctuations in the market by either decreasing or increasing the liquidity ratio besides driving the interest rates smoothly (Cour-Thimann & Winkler, 2012). Forth, the ECB can integrate structural operations to facilitate the appropriate adjustment of the region’s financial position.

Standing Facilities

The ECB uses standing facilities as an instrument for offering and attracting overnight liquidity besides indicating the stance of the monetary policy. Credit institutions in the Euro area facilitate the implementation of standing facilities and not the ECB. The two standing facilities offered include the marginal lending and the deposit services (Eser & Schwaab, 2016). The marginal lending facility as an instrument that seeks to foster price stability offers banks an opportunity to acquire loans repaid to the individual national banks on an overnight basis. On the other hand, the deposit facility allows credit institutions to place overnight deposits with the national banks in their respective states. Thus, the standing facilities go a long way in facilitating the analysis of the economy on a short-term basis.

Minimum Reserves

The ECB requires the entire banks in the Euro area to maintain a specified amount of minimum reserves on the current accounts with their corresponding national central banks. The minimum reserves tool stabilises the interest rates offered by various banks in the region, thus effectively responding to the temporary liquidity fluctuations (European Central Bank, 2017). Therefore, the approach influences banks to appropriately demand credit facilities from the central banks in the member states.

Conclusion

The ECB acts as the central bank of the Eurozone. The institution has the primary objective of fostering price stability in the Euro area. The ECB engages in different actions, including the definition of price elasticity, to foster its essence in the region. The need to realise the objectives of the ECB prompts it to adopt strategies, including the quantitative definition of price stability and the two-pillar approach. The application of the strategies incorporates tools such as open market operations and minimum reserves. Through the approaches, the ECB has realised considerable success in stabilising the Euro currency.

References

Blot, C., Creel, J., Hubert, P., Labondance, F., & Saraceno, F. (2015). Assessing the link between price and financial stability. Journal of financial Stability, 16(1), 71-88.

Borio, C., & Disyatat, P. (2010). Unconventional monetary policies: An appraisal. The Manchester School, 78(1), 53-89.

Cour-Thimann, P., & Winkler, B. (2012). The ECB’s non-standard monetary policy measures: The role of institutional factors and financial structure. Oxford Review of Economic Policy, 28(4), 765-803.

Criste, A., & Lupu, I. (2014). The central bank policy between the price stability objective and promoting financial stability. Procedia Economics and Finance, 8(1), 219-225.

de Haan, J., & Kooi, W. (2000). Does central bank independence really matter? New evidence for developing countries using a new indicator. Journal of Banking & Finance, 24(1), 643-664.

De Santis, R. A., Favero, C. A., & Roffia, B. (2013). Euro area money demand and international portfolio allocation: A contribution to assessing risks to price stability. Journal of International Money and Finance, 32(1), 377-404.

Dieckmann, S., & Plank, T. (2011). Default risk of advanced economies: An empirical analysis of credit default swaps during the financial crisis. Review of Finance, 16(4), 903-934.

Eser, F., & Schwaab, B. (2016). Evaluating the impact of unconventional monetary policy measures: Empirical evidence from the ECB’s securities markets programme. Journal of Financial Economics, 119(1), 147-167.

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Gambacorta, L., Hofmann, B., & Peersman, G. (2014). The effectiveness of unconventional monetary policy at the zero lower bound: A cross‐country analysis. Journal of Money, Credit and Banking, 46(4), 615-642.

Giannone, D., Lenza, M., Pill, H., & Reichlin, L. (2012). The ECB and the interbank market. The Economic Journal, 122(564), 467-486.

Nautz, D., & Scharff, J. (2012). Inflation and relative price variability in the euro area: Evidence from a panel threshold model. Applied Economics, 44(4), 449-460.

Panico, C., & Purificato, C. (2013). Policy coordination, conflicting national interests and the European debt crisis. Cambridge Journal of Economics, 37(1), 585-608.

Smets, F. (2014). Financial stability and monetary policy: How closely interlinked? International Journal of Central Banking, 10(2), 263-300.

Subbarao, D. (2012). Price stability, financial stability, and sovereign debt sustainability policy challenges from the new trilemma. Macroeconomics and Finance in Emerging Market Economies, 5(2), 246-259.

Szczerbowicz, U. (2015). The ECB unconventional monetary policies: Have they lowered market borrowing costs for banks and governments? International Journal of Central Banking, 11(4), 91-127.

Wright, J. H. (2012). What does monetary policy do to long‐term interest rates at the zero lower bound? The Economic Journal, 122(564), 447–466.

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