Week three - the economic and monetary union Flashcards
what are the two methods to monetary integration
- fixing the exchange rate and strong cooperation between national central banks
- introduction of a common currency under a common central bank
what does the economic and montary union in the EU consist of
- single monetary policy
- single currency (euro)
- close coordination of economic and fiscal policies
pros and cons of flexible (floating) exchange rate
- allows for an independent monetary policy
- protection of domestic economy from external shocks
- provides automatic solution to external deficit
BUT - created instability and uncertainty
- encourages speculative activities
- may be inflationary
pros and cons of fixed exchange rates
- promotes international trade and investment
- diminishes speculation
BUT - inherently unstable
- affects internal policy
- requires large holdings of foreign exchange reserves
- doesn’t allow for automatic balance of payments imbalances
how can inflation and unemployment spread from devaluation of currency
- imports become expensive
- companies may see their costs rising and may have to shift such rise to prices
- workers see their standard of living fall and demand higher salaries
- if salaries grow more than productivity, this may lead to unemployment
economic benefits of a currency area
- transaction costs diminish
- prices become comparable across countries (more competition)
- uncertainty of ER diminishes
- increase in trade
- increase in growth rate
- improved discipline and credibility of monetary policy both in the short and long-run
economic costs of a monetary union
- asymmetric shocks increase macroeconomic instability
- monetary policy loses autonomy (unless business cycles are synchronised and reactions to external shocks are similar/countries have similar tolerance towards inflation)
what is the optimal currency area theory
it considers the costs and benefits of a monetary union to determine if a number of countries is well-suited to share currency
what does an optimal currency area imply
total rigidity of exchange rates inside and full flexibility outside
why are countries better suited to share their currency
- less costly
- more beenficial
when can countires exploit the benefits of sharing a currency
- when the countries are open to trade and trade heavily with each other
- have production and exports widely diversified and of similar structure
- have similar inflationary path and high degree of real convergence and coordinated economic policy
- high degree of financial integration and free movement of capital
- have labour mobility and wage flexibility
- agree to compensate each other for adverse shocks (sharing a system of fiscal transfers)
- share a consensus on how to deal with shocks
regarding the EMU, when faced with asymmetric shocks, what factors are missing to fulfill the criteria
- flexibility in the labour market (wage and mobility)
- a system of fiscal transfers
- some heterogeneity among national preferences regarding economic policy
- solidarity
- leading to an uncertain result
what are the main reasons that prompted the creation of the EMU
- political
- economic: avoid the coexistence of four incompatible elements: full goods and services mobility, full capital mobility, fixed exchange rates, autonomous monetary policies
when was the first attempt to make the EMU
1970 - Werner report - failed
when was the EMU created and what exchange rate system did they use
1979, fixed but adjustable exchange rates
what is the delors report
it laid out the stages to create the EMU (1989)
what did the Maastricht treaty determine (1992)
the common currency should be created by 1999
what were the five entry conditions for the Maastricht treaty
convergence criteria:
- inflation (below a cieling)
- long-term nominal interest rates (ceiling and stable)
- stable exchange rates
- limited budget deficit (3% of GDP)
- limited public debt (60% GDP)
what is the stability and growth pact
1997: set conditions on the evolution of budget deficit (after entry) and procedures in case of failure
when was the ECB created
in 1998 (ecofin determined which countries filled the convergence criteria)
when were exchnage rates irrevocably frozen
1999 - national currencies ceased trading in foreign exchange markets, monetary policy was also transferred to the ECB
when were euro banknotes and coins introduced
2002
what is the european system of central banks composed of
- ECB
- NCBs (national central banks of all members)
what does the eurosystem composed of
- ECB
- NCBs of countries which have joined the monetary union
what body implements the monetary policy in the eurozone
eurosystem
characteristics of the ECB
- independent of political authorities
- high concentration of competency
exclusive powers of the eurosystem
- implements monetary policy in the eurozone
- holds and manages the eurozone official foreign-currency reserves
- authorises central banks in eurozone countries to issue euro banknotes
shared powers of the eurosystem
- exchange rate policy (with ecofin-19 and commission)
- helps ensure financial markets and institutions are adequately supervised by national authorities, and that payment systems function smoothly
what is the composition of the executive board of the EMU
president, vice-president, other members appointed by the European council, on a non-renewable term of 8 years
what are the responsibilities of the executive board
implement monetary policy for the euro area following the decisions of the governing council
composition of the governing council (main decision-making body)
executive board + governors of the national central banks of the euro area countries (minimum lenght of five years in office)
responsibilities of the governing council
- adopt the guidelines and make the decisions necessary to ensure the performance of the tasks entrusted to the Eurosystem
- formulate monetary policy for the euro area
- adopt decisions regarding the framework under which supervisory decisions are taken
what are the voting rights of the governing council
- executive board members hold permanent voting rights
- governors belonging to the five largest economies in the eurozone share four voting rights
- the rest of the governors share 11 voting rights
composition of the general council
- president and vice-presidents of the ECB
- governors of the NCBs of member states
responsibilities of the general council
- contributes to the ECBs advisory and coordination work
- helps prepare the new countries joining the euro
what is meant by transitional body (general council)
it will be dissolved once all member states have introduced the single currency
composition of the supervisory board
- one chair and one vice chair and 4 ECB representatives of national supervisors
responsibilities of the supervisory board
carries out the ECBs supervisory tasks
what is the main goal of the Maastricht treaty
price stability in the long-term, defined as a year-on-year increase in the harmonised index of consumer prices (HICP)
other objectives of the Maastricht treaty
support the general economic policies in the union
what is the transmission mechanism of the monetary policy
- the process by which the monetary policy decisions affect the economy in general and the price level in general
- characterised by long, variable and uncertain time lags
- the precise effects of the monetary policy on the economy and the price level are difficult to predict
what are the two pillars of price stability
- economic analysis (analysis of economic dynamics and shocks)
- monetary analysis (analysis of monetary trends)
what is the medium term
2-3 year horizon
how does monetary policy operate
by steering short-term interest rates, and influencing economic developments in order to maintain price stability for the euro area over the medium term
what are the operative variables of monetary policy
- money supply (liquidity)
- very short-term interest rates (EONIA - European over night index average), a weighted average of all overnight unsecured lending transactions in the interbank market
OR - @Ester (euro short-term rate), a rate that reflects the wholesale euro secured overnight borrowing costs of euro area banks, investment and pension funds
what are the instruments established by the ECB to control liquidity and interest rates
- minimum reserve requirements for credit institutions
- open market operations (four categories, most important is the main refinancing operations)
- standing facilities to absorb or provide overnight liquidity, also known as discount window policy
what are the two types of standing facilities
- marginal lending facility: banks can obtain overnight liquidity
- deposit facility: banks can make overnight liquidity, ( little incentive to use them as interest rates are unfavourable)
what does an open market operation consist of
the purchase and sale of public debt bonds by the central bank which increases or decreases the liquidity of the financial system according to the needs of the economy
what are the effects of each open market operation
- increase interest rates: the higher the interest rate the higher the return, the more assets the banks have and thus less liquidity
- reduction of interest rates have the opposite effects
- sales of bonds by banks will decrease liquidity because they will spend their money on acquisition
- purchase of bonds will have the opposite effect
what does the ‘discount’ refer to
the discount rate is the interest rate at which the transaction is performed
what are the two important roles of the discount
- provides cash reserves when needed with little notice
- facilitates monetary reserves when credit conditions worsen
what are the two important roles of the discount
- provides cash reserves when needed with little notice
- facilitates monetary reserves when credit conditions worsen
when do discounts become important
when there is a nervousness and lack of confidence in the financial system, this role is known as the lender of last resort
what are most banks required to do in terms of reserves
- keep money reserves in proportion to their customers’ deposits
- these reserves guarantee a minimum liquidity and solvency in the system
what is the monetary transmission mechanism
the route by which monetary policy affects output, employment, prices and inflation
what are the steps of monetary transmission mechanism
1) CB raises the interest rate target based on the state of the economy
2) CB undertakes open-market operations
- to slow the economy, it would sell securities, reducing reserves and raising short-term interest rates
- if a recession threatened, the CB would buy securities, increasing the supply of reserves and lowering short-term interest rates
3) asset markets react to policy changes
- higher interest rates tend to reduce asset prices (stocks, bonds, houses) and tend to raise foreign exchange rates in a flexible exchange rate system
4) investment and other spending react to interest rate changes
- higher interest rates, tighter credit, lower wealth and higher exchange rate tends to reduce investment, consumption and net exports
what are non-standard monetary operations
unprecedented measures in response to financial crises
when did non-standard monetary operations become important
since autumn 2008 (financial crisis)
what are some other measures used to support a financial crisis
- improved system of financial supervision
- financial assistance mechanisms or bail-outs
- increased economic governance
- reforms to increase competitiveness
what are some concerns with monetary policies being common in the EU
- too big budget deficits could affect stability in the eurozone
- too much public debt could increase interest rates in the eurozone and put pressure on the ECB to buy public debt
what is the stability and growth pact
a framework for coordination of national fiscal policies, there is prevention (countries submit stability programmes yearly) and correction (sanctions when rules are breached)
why was the growth and stability pact discredited
france and germany failed repeatedly to comply with from 2001
what was the aim of the lisbon strategy
to make the EU the most competitive and dynamic economy in the world capable of sustainable economic growth
what were the five areas of targets of europe 2020
- employment
- R and D
- climate change and sustainability
- education
- fighting poverty and social exhaustion
who monitored Europe 2020
european semester
what is the european semester
the EU’s annual cycle of economic and fiscal policy coordination
what three blocks of economic policy coordination does the european semester cover
- structural reforms
- fiscal policies
- prevention of excessive macroeconomic imbalances
how did the financial crisis turn into a recession
- american homeowners defaulted on their mortagages
- spread to banks all over the world
- bankruptcies started (banks stopped lending to each other)
- intervention of CBs
- recession hit in 2009
what did the keynesian policies in 2008/9 lead to
budget deficits –> increase in public debt, fall in tax revenue and increasing spending on crisis-related expenses, higher doubt on the governments ability to pay their debts back, ultimately leading to the sovereign crisis
