Transcript Slide 1

International Monetary Economics
Feb 24 2004
Lesson 6
By
John Kennes
The European Monetary Union
Feb 24 2004
The launch of the euro represents
the end of a long process
Feb 24 2004
The Maastricht Treaty
Feb 24 2004
•
•
•
•
A firm commitment to launch the single currency by
January 1999 at the latest.
A list of five criteria for admission to the monetary
union.
A precise secification of central banking institutions.
Additional conditions mentioned (e.g. The excessive
deficit procedure).
The Maastricht Convergence Criteria
1. Inflation
–
Not to exceed by more than 1.5% the average of the 3 lowest.
2. Long-term interest rate
–
Not exceed by more than 2% the average of the low 3 above
3. ERM membership
– At least 2 years in ERM without being forced to devalue
4. Budget deficit
–
Deficit less than 3% of GDP
5. Public debt
–
Debt less than 60% of GDP
Inflation criteria: A fear of allowing in
unrepentant inflation-prone countries
Feb 24 2004
10.00
5.00
0.00
1991
France
Spain
Belgium
Greece
1992
1993
1994
1995
1996
1997
1998
Italy
Germany
Portugal
average of three lowest + 1.5%
Long-term interest rate criteria: A little too
easy to bring inflation down in 1997
Feb 24 2004
•
•
•
•
Too easy to bring down inflation in 1997 – artificially or
not – then let go again.
Long-term interest rates incorperate bond market
expectations of long term inflation.
So criteria requires convincing markets
Problem: self-fulfilling prophecy
–
–
If markets believe admission to euro area, they expect low
inflation and long-term interest rate is low, which fulfills the
admission criteria
Conversely, if ...
ERM membership:
same logic as long-term interest rate criteria
Feb 24 2004
•
•
•
Need to convince the exchange market. Need to show a
non-superficial conversion to price stability.
Membership demonstrates the country’s ability to keep
its exchange rate tied to its future monetary union
partners
Problem: same aspect of self-fulfilling prophecy
Budget Deficit and debt criteria:
historical view
Feb 24 2004
•
•
•
Historically, all big inflation episodes born out of
runaway public deficits and debts.
Hence requirement that house is put in order before
admission
How are ceilings choosen?
–
–
Deficit: the German golden rule (public infrastructure
investment about 3% of GDP)
Debt: the 1991 EU average
Budget Deficit and debt criteria:
Problems
Feb 24 2004
•
Problem No. 1: A few years of budgetary discipline do
not guarantee long-term discipline:
–
•
The excessive deficit procedure will look to that once in the
euro area, more later.
Problem No 2: Artificial ceilings
–
The Belgium clause
Budget Deficit and debt criteria: in 1997
Feb 24 2004
Maastricht fiscal criteria 1997
120
Public Debt (%GDP)
100
80
60
40
20
0
-3
-2
-1
0
1
Deficit (% GDP)
2
3
4
5
A tour of the Acronyms
Feb 24 2004
•
•
•
•
N countries with N central banks (NCBs) that continue
operating but with no monetary policy function
A new central bank at the centre: the European Central
Bank (ECB)
The European System of Central Banks (ESCB): the ECB
and all EU NCBs (N=15)
The Eurosystem: the ECB and the NCBs of euro area
member countries (N=12)
The System
Feb 24 2004
How does the Eurosystem operate?
Feb 24 2004
•
Objectives
– What is it trying to achieve?
•
Instruments
–
•
What are the means available?
Strategy
–
How is the system formulating its actions?
Objectives (1)
Feb 24 2004
•
The Maastricht Treaty’s Aricle 105:
– The primary objective of the ESCB shall be to maintain price
stability. Without prejudice to the objective of price stability,
the ESCB shall support the general economic policies in the
Community with a view to contibuting to the achievement of
the Community as laid down in Article 2.
•
In clear
–
–
Fighting inflation is the absolute priority.
Supporting growth and employment comes next.
Objectives (2)
Feb 24 2004
•
•
Making the inflation objective operational: does the
Eurosystem have a target?
No, it has a definition of price stability.
–
–
`Price stability is defined as a year-on-year increase in the
HarmonizedIndex of Consumer Prices (HICP) for the euro
area of below 2%. Price stability is to be maintained over the
medium term´
`The governing council agreed that in the pursuit of price
stability it will aim to maintain inflation rates close to 2% over
the medium term.
Objectives (2) comment
Feb 24 2004
•
Leaves room for interpretation
– Where below 2 per cent?
– What is the medium term?
Instruments (1)
Feb 24 2004
•
Recall the channels of monetary policy
–
–
–
–
•
•
•
Longer run interest rates
Credit
Asset prices
Exchange rate
These are all beyond the central bank control
Instead it can control the very short-term interest rate:
European overnight Index (EONIA)
EONIA affects the channels through market
expectations
Instruments (2)
Feb 24 2004
•
The Eurosystem controls EONIA by establishing a
ceiling, a floor and steering the market in-between.
–
–
–
The floor: the rate at which the Eurosystem accepts deposits
(the deposit facility)
The ceiling: the rate at which the Eurosystem stands ready to
lend to banks (the marginal lending facility)
In-between: weekly auctions (main refinancing facility)
EONIA & Co.
Feb 24 2004
7
6
5
4
3
2
1
EONIA
Deposit facility
Marginal lending facility
Main refinancing
0
Jan.99 Jul.99 Jan.00 Jul.00 Jan.01 Jul.01 Jan.02 Jul.02 Jan.03 Jul.03
The Two-Pillar Strategy
Feb 24 2004
•
•
The monthly Eurosystem’s interest rate decisions (every
month) rests on two pillars.
Economic analysis
–
Broad view of economic conditions:
•
•
Growth, employment, exchange rates, abroad
Monetary analysis:
–
Evolution of monetary eggregates (M3, etc.)
Comparison with other strategies
Feb 24 2004
•
The US Fed:
– Legally required to achieve both price stability and a high level
of employment
– Does not articulate an explicit strategy
•
Inflation-targeting central banks (Czech Republic,
Poland, Sweden, UK, etc):
–
–
Announce a target (e.g. 2.5% in the UK, a margin (e.g. +/- 1%)
and a horizon (2-3 years)
Compare inflation forecast and target and act accordingly
Taylor Rule Interpretation: Suppose ECB
sets interest rates by the Taylor Rule
Feb 24 2004
•
Taylor rule: i=i*+a(p-p*)+b(y-y*)
– where i* is the equilibrium interest rate, p is the inflation rate
and p* the inflation objective, y is the GDP growth rate and y*
is the GDP growth trend.
– Central bank raises interest rates if inflation exceeds target.
•
Using the Fisher principle: i*=r*+p*
–
–
•
Take: p*=2% and i*=4% (2% real, 2% target inflation)
Choose a and b: a=2.0, b=0.8 (care about both inflation and
cyclical flucuations with emphasis on latter)
Compare with the actual EONIA
A Reasonable Fit: Suppose ECB sets
interest rates by the Taylor Rule
Feb 24 2004
Inflation
3.5
8
3
7
2.5
2
6
1.5
1
5
0.5
0
Q1-1999
4
Q1-2000
Q1-2001
Q1-2002
Q1-2003
3
Output gap
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
Q1-1999
2
1
0
Q1-1999
Q1-2000
Q1-2001
EONIA
Q1-2000
Q1-2001
Q1-2002
Q1-2003
Q1-2002
Taylor rule
Q1-2003
Does One Size Fit All?
Feb 24 2004
•
•
•
With one monetary policy, particular national
conditions cannot be attended to.
This is another version of the asymmetric shock concern
of the OCA theory: the cost must be borne.
Monetary policy may also effect differently different
countries.
Independence and Accountability
Feb 24 2004
•
Current conventional wisdom is that central banks
ought to be independent:
–
–
•
•
•
Government tend not to resist to the `printing press´
temptation
The Bundesbank has set an example
But misbehaving governments are eventually punished
by voters
What about central banks? Independence removes them
from suc pressure
A democratic deficit?
Redressing the Democratic Deficit
Feb 24 2004
•
In return for their independence, central banks must be
held accountable
–
–
•
to the public
to elected representaives
Examples:
–
–
The Bank of England is given an inflation target by the
Chancellor. It is free to decide how to meet the target, but it
must explain its failures (the letter)
The US Fed must explain its policy to Congress, which can
vote to reduce the Fed’s independence
The Eurosystem Weak
Accountability
Feb 24 2004
•
•
•
The Eurosystem must report to the EU parliament
The Eurosystem’s President must appear before the EU
Parliament when requested, and do so every quarter
But the EU Parliment cannot change the Eurosystem’s
independence and has limited public visibility
The Record So Far
Feb 24 2004
•
A difficult period
–
–
–
–
–
An oil shock in 2000
A worldwide slowdown
September 11
The stockmarket crash 2002
Afghanstan, Iraq
Inflation: Missing the Objective a Little
Feb 24 2004
3.5
3
2.5
2
1.5
1
0.5
Jan.99
Jan.00
Jan.01
Jan.02
Jan.03
The Euro: Too Weak First, Then too
Strong?
Feb 24 2004
The euro/dollar exchange rate
1.2
1.1
1
0.9
0.8
Jan.99 Jul.99 Jan.00 Jul.00 Jan.01 Jul.01 Jan.02 Jul.02 Jan.03 Jul.03
But No Seriously Asymmetric
Shocks
Feb 24 2004
Inflation
GDP growth
14.0
20.0
12.0
15.0
10.0
8.0
10.0
6.0
5.0
4.0
0.0
2.0
-5.0
0.0
1991 1993 1995 1997 1999 2001 2003
Average
Min
Max
1991 1993 1995 1997 1999 2001 2003
Average
Min
Max
Next class
Feb 24 2004
Discussion of the class project.
–
–
–
–
–
–
Choice of topic and coauthor (3 or 4 questions per topic from a
set of 6 topics, optional 7 th project)
Project format (3000 words etc)
Web Publication of Projects (names will be withheld)
Referee reports (300-400 words)
Web publication of referee reports (names will be witheld)
JEH