Wayne State University
Department of Economics
Macroeconomics – ECO 6050
Winter 2006

“The Monetary Policy of the
European Central Bank – Maintaining Price Stability”

Submitted by:

Tim Bachinger

TABLE OF CONTENTS

TABLE OF CONTENTS II

1. Introduction 1

2. Economic and Financial Structure of the Euro area 2

3. The European Central Bank 3
3.1. Structure - The Eurosystem 3
3.2. Decision-making Bodies of the ECB 4
3.3. Basic Tasks of the Eurosystem 3

4. Independence 4

5. Transparency - Accountability and Credibility 5

6. The ECB Monetary Strategy 9
6.1. Quantitative Definition of Price Stability 9
6.2. Economic and Monetary Analysis 9

7. Monetary Policy Instruments 12
7.1. Open Market Operations 12
7.2. Standing Facilities 12
7.3. Minimum Reserve Requirement 12

8. Single Monetary Policy in Practice - Experience of the First Five Years 12
8.1. Contribution to the Banking Systems Liquidity 12
8.2. Monetary Policy between 1999 and 2003 12

APPENDIX 13

REFERENCES 15

1. Introduction

Since 1 January 2001 the euro is the currency of 12 European countries. On exactly that date, the euro was introduced as the new national currencies of Belgium, Germany, Spain, France, Greece, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. Only three of the European Union (EU) Member States, Denmark, Sweden and the United Kingdom have refused to introduce the euro. The introduction for more than 300 million European citizens resulted in putting 7.8 billion euro notes and 40.4 billion euro coins, together worth €144 billion, in general circulation. At the same time, each country begun to withdraw their former national currency notes and coins from circulation.¹ Four years earlier, on 1 June 1998, the European Central Bank (ECB), located now in Frankfurt am Main (Germany) was established to be in charge of monetary policy for the Euro area. The introduction of the euro and the establishment of the ECB were both realizations of the European Monetary Union. Three individual stages should lead to this European Monetary Union.² Stage One of the European Monetary Union was started in July 1990. The stage concluded that all restrictions on the movement of capital between Member States were abolished. The establishment of the European Monetary Institute on 1 January 1994, the forerunner of the ECB, begun the second stage.³ Its main tasks were to “strengthen central bank cooperation and monetary policy coordination”. In additon, it should make the preparations required for the establishment of the European System of Central Banks (ESCB), consisting the ECB and the local national central banks of all EU Member States. Its primary task is to conduct the single monetary policy and besides that, in the third stage, to create a single currency. On 1 January 1999, the third and final stage of European Monetary Union started with the fixing of the exchange rates of the currencies of the Member States participating in Monetary Union.

One the same date, the ECB was now legaly responsible for the conduct of the single monetary policy in the Eureo area.⁴ To sum these stages up, the ECB is the central bank for Europe′s single currency, the euro. The ECB’s task is to maintain the euros purchasing power, thus obtain price stability. The ECB has got several instruments to achieve this goal. The use of these instruments can be summarized as “monetary policy” of the ECB. This paper will first describe the structure and organization of the ECB. After that, it focuses on the ECB’s monetary policy strategy and its individual monetary policy instruments. Finally the paper will describe the direction and actions of the monetary policy in the Euro area of the first five years (1999-2003).

2. Economic and Financial Structure of the Euro area

To achieve price stability the ECB is required to recognize and understand the different factors that influence the price level of the Euro area. Thus, I will describe the economic and financial structure of the Euro. In 2002, the Euro area had a total population of 307.8 million, the largest developed economy in terms of population. Just like in other developed economies, the service sector has the largest share of total output, followed by the industrial sector.⁵ It had a 15.7% share of world GDP and is thus the second largest economy after the United States. The shares of the individual Euro area countries were much smaller, the largest economy within the Euro area, Germany, had only a 4.4% share of world GDP in 2002. The unemployment rate in the Euro area averaged 8.4% corresponding to a total of about 11.7 million unemployed work force participants in 2002. Government expenditure exceeded revenues in 2002, recording deficits to 2.2% of GDP. The share of worldwide GDP exports had been 31.2% in 2002. The two largest external trade partners are the United Kingdom and the United States, combining more than 30% of total trade.⁶

[....]

1 ECB (ECB Information brochure), p. 7.

2 For a summary of the European Monetary Union stages, see Appendix.

3 Dominguez (The ECB, the Euro and Global Financial Markets), p. 1-8.

4 Kool (What Drives ECB Monetary Policy), p. 1-3.

5 Issing (Monetary Policy in the Euro Area), p. 47-51.

6 ECB (The European Central Bank – History, role and functions), p. 17-25.