The effect of the European Central Bank's monetary policy on the real estate market in Germany

Table of content

Table of content

List of figures

1 Introduction

2 Monetary Policy
2.1 Term discussion
2.2 Instruments
2.3 Expansionary monetary policy
2.4 Contractionary monetary policy
2.5 Approaches

3 Effects of on the European real estate market
3.1 European monetary policy
3.2 Current policy of the European central bank
3.3 The German real estate market
3.4 Influence of monetary policy on real estate

4 Conclusion

Bibliography

Internet sources

List of figures

Figure 1: German housing market

1 Introduction

The prices for real estate in Germany are continuously rising at a steady level. High sought-after cities are not only affected by the positive price trend but far beyond that also less sought-after regions. On the other hand, the European Central Bank has been pursuing a policy of low-interest rates for years, which has been extended by various purchase programmes, especially since the financial crisis and during the current pandemic. A connection between monetary policy and the development of real estate prices can be deduced. Many interest-bearing savings products are expiring, and the low- interest rates make a new investment less attractive. Besides, Germans do not like shares or bond as an investment, the demand for flats and houses, which are seen as supposedly safe investments, has increased. The past has shown how quickly an overheated real estate market can lead to price bubbles and severely shake financial stability.¹

The following term paper analyses the European monetary policy and its effects on the real estate market. The term paper is divided into two main parts. The first part includes a theoretical discussion of monetary policy and introduces the European central bank its policy. It provides an introduction to the different instruments and their effects. The second part is a short assessment of the European central banks its current approach. Afterwards, there will be an introduction to the German housing market and an explanation of how it is affected by the European central bank its policy. The background and the current issue will be discussed. In the end, there will be a summary with a conclusion of this term paper.

2 Monetary Policy

2.1 Term discussion

“Monetary policy, the demand side of economic policy, refers to the actions undertaken by a nation's central bank to control money supply and achieve macroeconomic goals that promote sustainable economic growth.“²

In detail, monetary policy includes all measures with which the central bank, in particular, controls the circulation of money, its supply and credit to the economy. In general, there are different objectives of monetary policy. These are typically derived from the central banks. At the European Central Bank, this is price level stability.³

The most important goal is to safeguard the currency, i.e., maintain the value of money within the economy and the stability of purchasing power externally. This goal requires above all the control of the money supply in circulation. Money must be scarce that the value of money does not suffer, but also a sufficient supply of the economy with money must be guaranteed in order to be able to carry out all monetary transactions.⁴

The US its central bank (Federal Reserve System) has a growth and employment objective in addition to price level stability. In contrast, the European Central Bank has the secondary objective of supporting general economic policy. So far, central banks also monitor exchange rate targets. Nevertheless, there are also central bank policy objectives. These are intermediate objectives that are pursued in the fulfilment of economic policy objectives. The intermediate target is thus an indicator that determines whether the economic policy objective can be met. Therefore, the target can be the change in the interest rate, the money supply, the inflation rate, the price index, economic growth or a combination of several targets.⁵

2.2 Instruments

To achieve its primary objectives, the central banks use various monetary policy instruments and procedures. The interest rate policy defines the central bank measures to influence the general level of interest rates. By changing interest rates, the central bank aims to influence the demand for investment loans by companies or consumption loans by households and the demand for credit by the state.⁶ If, for example, the central bank raises its interest rates to reduce price increases in a cyclical boom, the commercial banks will also raise the interest rates they charge their customers. Higher interest rates cause lower demand for loans, e.g., for investments, as companies its profit outlook decreases. The result is a reduced demand for money, the price level stabilises. Interest rate hikes have a similar effect on the demand for consumer goods by private households. Falling interest rates have the opposite effect.⁷

Liquidity policy includes the central bank's ability to influence commercial banks its liquidity through monetary policy tools such as changes in reserve ratios under the minimum reserve policy or through changes in interest rates for refinancing operations under the interest rate policy.⁸ Permanent facilities are used to provide overnight liquidity or to withdraw it. They provide signals regarding a central bank its general stance and set upper and lower limits on overnight money market rates. Credit institutions can obtain any shortfall in funds from the central bank overnight on precisely pre­determined, uniform terms. This process is called marginal lending facility. If the banks deposit surplus funds with the central bank overnight, it is called a deposit facility. The permanent facilities also serve to ensure the liquidity of commercial banks.⁹ The reserve policy includes percentage rates which set the proportion of customer deposits that banks and savings banks must maintain with the central bank as interest-free balances. These minimum reserve ratios vary depending on the type of deposits (demand deposits, time deposits or savings deposits). The higher the central bank its minimum reserve ratios, the tighter the money supply is kept. The commercial banks have less money available to lend to their customers. On the other hand, if the central bank lowers the minimum reserve ratios, it improves the liquidity of the commercial banks and their money creation through the granting of loans increases.¹⁰ A further tool describes the open market operations. The term is used to purchase and sell securities by the central bank on the money or capital market. The trading may be in short- or long-term securities and may be executed by the central bank either outright or for a specified period of time. Open market transactions are purchases or sales of securities by the central bank without a redemption agreement. On the other hand, the securities are only purchased by the central bank for a certain period of time, and the selling credit institution is obliged to repurchase them, this is a repurchase agreement.¹¹ Another tool of a central bank is the foreign exchange. In foreign exchange intervention, the central bank acts as a buyer, supplier of domestic currency or foreign exchange to achieve the exchange rate it is aiming for. In a currency system with agreed fixed exchange rates, the central bank has to intervene in order to be able to influence the exchange rate in an emergency.¹²

2.3 Expansionary monetary policy

Expansionary monetary policy aims to expand the money supply or the supply of money to stimulate the economy, for example, during a recession. The expansionary monetary policy is used, when a central bank increases the money supply at the commercial banks, they are in a position to grant more loans. A reduction usually follows the higher supply of credit in the lending rate, which significantly increases credit demand. Credit-financed spending on consumer and capital goods increases, which in turn boosts production and employment. Thus, expansionary monetary policy is primarily a monetary policy instrument used when short-term stabilisation of business cycles is necessary to lead the economy out of a recession or keep it out of one. The flip side of an expansionary monetary policy, on the other hand, is the rise in inflation. In the short run, expansionary monetary policy has a real and rapid effect on an economy its output or interest rate. In the medium and long term, however, it is ineffective. In the end, it only leads to an increase in the price level. Long term production is above its natural level, and the price level rises over time since the additional production causes the unemployment rate to fall, and thus wages and prices to rise. As a result, the real money supply continues to decline, and the interest rate rises again. Investment demand and production decline accordingly. In the medium and long term, the increase in the nominal money supply is therefore fully reflected in a proportional increase in the price level.¹³

Expansive monetary policy can become a problem if the central bank increases the money supply far beyond the set target. However, an expansionary monetary policy can also have the opposite effect. In this case, the increase in prices will be followed by an increase in interest rates, which will increase the nominal interest rate. The increase in the money supply, therefore, even has a restrictive effect.¹⁴

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¹ See, https://www.globalpropertyguide.com/Europe/Germany/Price-History, access 08-Feb-21

² https://www.investopedia.com/terms/m/monetarypolicy.asp, access 23-Jan-2021

³ See, Theiler W., Makroökonomie, 2012, p.293

⁴ See, https://www.bpb.de/nachschlagen/lexika/lexikon-der-wirtschaft/19456/geldpolitik, access 23-Jan- 2021

⁵ See, Theiler W., Makoökonomie, 2012, p.298 et seq

⁶ See, https://www.ecb.europa.eu/mopo/implement/html/index.de.html, access 06-Jan-21

⁷ See, https://www.bpb.de/nachschlagen/lexika/lexikon-der-wirtschaft/21275/zinspolitik, access 23-Jan- 2021

⁸ See, https://www.bpb.de/nachschlagen/lexika/lexikon-der-wirtschaft/19988/liquiditaetspolitik, access 23-Jan-2021

⁹ See, Theiler, W. Makroökonomie, 2012, p.303 et seq

¹⁰ See, https://www.bpb.de/nachschlagen/lexika/lexikon-der-wirtschaft/20119/mindestreservepolitik, access 23-Jan-2021

¹¹ See, Theiler, W., Makroökonomie, 2012, p. 298 et seq

¹² See, Theiler W., Makroökonomie, 2012, p. 300 et seq

¹³ See, https://corporatefinanceinstitute.com/resources/knowledge/economics/expansionary-monetary- policy/, access 06-Feb-21

¹⁴ See, https://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm, access 06-Feb-21