Monetary Policy in European Monetary Union - Essay Example

?Monetary policy in EMU (European Monetary Union) Introduction The European Monetary Union is the agreement between the s of the European Union to adopt a common currency for the countries. The currency that has emerged from the agreement has been named as the Euro. The rationale behind the formation of this association was creation of a strong single European market that would be beneficial for the wholesome economic development of all the member countries, to promote social unity among the people and most importantly, to enhance the prominence of Europe in the global economy (University of Iowa College of Law Center for International Finance and Development, 2013). Initially, the European Union included 12 countries, but since its inception in 1992, the area has expanded to include 17 countries in total (European Union, 2012). The financial crisis of 2007-08 had enhanced the importance of the austere economic regulation by the European Union. This essay covers the monetary policy that has been adopted by the European Union, keeping in mind the various pressing issues that have been a matter of concern in the European countries like, price stability, real economy stabilization and its future plans regarding inflation targeting. Monetary Policy of the European Monetary Union Rationale behind price stability and real economic stabilization Price stability implies that the purchasing power of citizens and the value of their savings will be independent to the exchange rate fluctuations in cross-border travels and investments. The Monetary policy in the Euro zone is conducted by the European Central Bank and has direct impact on the price stability and the interest rates. The main objective of the monetary policy by the EMU is to keep the rate of inflation hovering around 2%, so that the value of Euro can be protected (European Union, 2012). This is achieved by altering the rate of interest of lending by the banks. The objective of price stability in monetary policy is an integral part of maintaining moderate levels of inflation, so that the economy can avoid the risk of running into deflation. The European Central Bank and EMU have always tried to maintain the price stability because of the strong notion that by maintaining the price stability, the economic activity and employment levels of the country can be improved. The maintenance of price stability by the EMU ensures that the price level of any particular good or service acts independent to the general price level of the economy. Price stability also ensures that the creditors can be relaxed as the prices will not rise in future and there will be no need of inflation risk premium to compensate the losses from inflation. Unnecessary hedging activities and distortions in the tax and social security system can also be avoided by maintenance of price stability (European Central Bank, 2011). The price stability contributes to the stabilization of the real economy. Monetary Policy prior to the crisis Before the onset of the financial crisis, the EMU had been successful in maintaining the inflation rate, averaging to 2.04% from January 1999 to August 2007 (European Central Bank, 2012). This bears a testimony to the fact that since the formation of Euro, the Euro Zone has been quite successful in achieving its preliminary goal of maintaining price stability. The most interesting fact about the price stability in the EU was that the inflation rates were not only low, but also had low macroeconomic volatility compared to other advanced countries of the world. Figure 1: Inflation Rates in the Advanced Economies (Source: European Central Bank, 2012) The above figure shows the inflation rates in the industrialized economies of the world from 1999 to 2011. It can be seen that the monetary policy followed by the European Union, prior to the global financial crisis of 2007, has been in line with its objectives. In the course of time between 1999 and 2007, the European economy had undergone a lot of turmoil like, increasing global oil and food prices, increases in indirect taxes and increases in the administered costs. The monetary policy followed by the EMU adopted a medium-term orientation to deal with the exogenous shocks. It is practically impossible for any central bank in the world to keep the inflation target fixed in a short time as monetary policy can affect the developments in price after a certain time lag (Vitek, 2009). To deal with the adverse cost-push shocks like, the oil price increase, an aggressive monetary policy was not followed as they contribute to increase the volatility of the output and employment instead. Therefore, a gradual response by the EMU and its monetary policy has been effective in dealing with the situation. This type of a reaction may increase the inflation levels of the economy, but is beneficial in the long run (Cour-Thimann and Winkler, 2013). Monetary Policy during to the crisis With the global financial crisis wrecking havoc in the economies of the advanced countries, the monetary policy of the EMU had to be modified to deal with the volatility of the financial sector. In this regard, the EMU had taken unconventional policies to deal with the crisis at hand, including providing liquidity support to the banks, low policy rates over extended period and interventions by the Sovereign authority in the financial markets. The ECB had reacted by lowering the interest rates immediately so that the monetary policy could affect the correct transmission channels. With the deepening of the financial crisis in mid-2008, the central bank reduced interest rates to historically low level of 1% (Frangakis, 2011). The ECB, along with the EMU, had launched the Enhanced Credit Programme to improve the profitability of the banks in the Euro area. This policy included the following measures: Firstly, it included providing unrestricted liquidity at a fixed rate against collateral in all sorts of refinancing enterprises. Secondly, the maximum maturity period, in case of refinancing operations, were extended from three months prior to the crisis to one year for improving the grim economy. Thirdly, Asset Backed Securities were included in the definition of collateral. Fourthly, purchases were made from the covered bond markets with maturity from three to seven years and the regulatory authority had intended to hold the bonds until maturity. Finally, liquidity was provided in foreign currency with special attention to US dollars. The rationale behind introducing this policy was explained by the fact that securitization of the banks would increase their dependence on the financial market funding, at a time when the financial markets themselves are volatile. The other reason was that non-banking financial institutions are heavily dependent on the banks for their external financing (Frangakis, 2011). Another instrument that has been used is the Outright Monetary Transactions, which involves short-term sovereign bond purchases, subject to certain conditions, imposed by the European Stability Mechanism (Pattipeilohy, et al., 2013). Inflation Targeting In the recent economic times, inflation targeting has become one of the major outlooks of the banks compared to the initial method of controlling the growth of money supply (Sivak, 2013). In this process, the central banks try to maintain a low and stable annual rate of inflation that can be optimal to drive the economic development of the country. It is strongly believed that inflation targeting can maintain the price stability, which is the primary objective of the European Central Bank. Many commentators have argued that the policy followed by ECB has been restrictive rather than expansionary. It has been reasoned that the restrictive monetary policy to control rates of inflation can act in a restrictive way and offset the positive effects of the fiscal policy (Stroup, Sobel and Macpherson, n.d.). In the period of financial crisis, it has been found that the effectiveness of the monetary policy to impact the interest rates through transmission channels had been severely affected (Abbassi and Linzert, 2011). The inflation target of 2% by the ECB has come under the radar in the aftermath of the crisis (Weber, 2012). It has been observed that the member countries of the European Union are not all homogeneous which implies that needs of the countries vary according to specific conditions of the country. A research in this area is likely to be useful in the recent times of financial stress. Conclusion In this essay, the monetary policy of the EMU has been discussed. It has been pointed out that the European Central Bank controls the monetary policy in the Euro Zone. The monetary policy by the ECB has been studied and after an analysis, it can be concluded that the price stability is the primary objective of the policy. The Central Bank has made a consistent effort to maintain the inflation rates to a permissible level in order to propel a strong economic growth of the European area. The policy followed by the European Nations has been quite successful in maintaining the development of the region. However, with the global financial crisis, the effectiveness of the monetary policy has been questioned as the rate of inflation has gone down below the expected level of 2%, which had severely affected the growth of the European countries. The policy adopted during the crisis to fight it has also been covered. Reference List Abbassi, P. and Linzert, T., 2011. The Effectiveness Of Monetary Policy In Steering Money Market Rates During The Recent Financial Crisis. [pdf] European Central Bank. Available at: [Accessed 21 December 2013]. Cour-Thimann, P. and Winkler, B., 2013. The ECB’S Non-Standard Monetary Policy Measures The Role Of Institutional Factors And Financial Structure. [pdf] European Central Bank. Available at: [Accessed 21 December 2013]. European Central Bank, 2011. The Monetary Policy of The ECB. [pdf] European Central Bank. Available at: < https://www.ecb.europa.eu/pub/pdf/other/monetarypolicy2011en.pdf> [Accessed 21 December 2013]. European Central Bank, 2012. Monetary And Fiscal Policy Interactions In A Monetary Union. [pdf] ECB. Available at: [Accessed 21 December 2013]. European Union, 2012. Economic and monetary union and the euro. [pdf] Luxembourg: Publications Office of the European Union. Available at: [Accessed 21 December 2013]. Frangakis, M., 2011. ECB monetary policy prior to and in face of the crisis. [pdf] Nicos Poulantzas Institute. Available at: [Accessed 21 December 2013]. Pattipeilohy, C., Willem van den End, J., Tabbae, M., Frost, J. and Haan, J., 2013. Unconventional monetary policy of the ECB during the financial crisis: An assessment and new evidence. [pdf] Amsterdam: De Nederlandsche Bank. Available at: [Accessed 21 December 2013]. Sivak, T., 2013. In?ation targeting vs. nominal GDP targeting. [pdf] n.p. Available at: [Accessed 21 December 2013]. Stroup, R. L., Sobel, R. S. and Macpherson, D. A., n.d. Macroeconomics: Public and private choice make. Connecticut: Cengage Learning. University of Iowa College of Law Center for International Finance and Development, 2013. What Is the European Monetary Union (EMU)? [online] Available at: [Accessed 21 December 2013]. Vitek, F., 2009. Monetary policy analysis and forecasting in the world economy: A panel unobserved components approach. Washington D.C.: International Monetary Fund. Weber, H., 2012. One for all– The ECB’s Inflation Target. [pdf] The Kiel Institute for the World Economy. Available at: [Accessed 21 December 2013]. Read More