General Economics Monetary Policy

Table of Contents

Executive Summary

List of Figures

List of Abbreviations

1 Introduction

2 The European Central Bank
2.1 The objective of the European Central Bank
2.2 Instruments of the ECB and the mechanisms of action

3 The Market of Foreign Currency Exchange
3.1 Impact of Exchange Rates to the Economy
3.2 Measures and Policies against Currency Depreciation
3.2.1 External Measures (monetary policy) against currency depreciation
3.2.2 Possible reasons for US Dollar depreciation

4 Conclusion

Bibliography

Appendix 1 - ITM Checklist

Executive Summary

For now more than 6 years, starting in 2002, the US-Dollar continuously depreciates in relation to the Euro but also in relation to other strong currencies in the world.

The European System of Central Bank can help the dollar but not without affecting the Euro. A stable Euro with low and constant inflation of 2% is the main objective of the ECB and fixed in their statutes.

The depreciation of the dollar can be blended by depreciating the Euro in the same relation but that won’t help for long. The impacts on the domestic economy which consists of a range of multicultural states within the Euro Area would be unpredictable. At least high Inflation to the Euro would follow - with negative side effects to the European countries.

Even if a weaker Euro (or stronger Dollar) would help the German exporters the problem of the Dollar is not caused by the strong Euro. Germany is still leading in foreign trade and increases its net-export even though the Euro gets stronger. Since more than 20 years the USA have increased their trade-deficit year on year.

The solution for the weak dollar is not a weak Euro. Beside the tradedeficit the enormous costs for military interventions also charge the government budget and lately the population by inflation tax.

List of Figures

Figure 1 - € / US$ Exchange Rate History (Source ECB)

Figure 2 - An Increase in the Money Supply (Mankiw 2006, p.613)

Figure 3 - Transmission Mechanisms from Interest Rates (ECB 2004, p.45)

Figure 4 - A monetary injection (Following Mankiw 2006, p.718)

Figure 5 - Inflation Rate (HICP) for the Euro Area (Source: sdw.ecb.europa.eu)

Figure 6 - Historical US Inflation Data (Source: www.inflationdata.com )

Figure 7 - US Trade Deficit (source: lancewiggs.com)

List of Abbreviations

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1 Introduction

The exchange rate from Euro to US-Dollar has continuously been increased for now more than 6 years starting in the year 2002 as it is shown in Figure 1. This means the Dollar has continuously been depreciated and/or the Euro has continuously been appreciated in the meaning of mutual foreign purchasing power.

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Figure 1 - € / US$ Exchange Rate History (Source ECB)

A strong currency always affects the foreign trade in two different ways:
1) Imports from a country with a relatively weak currency, as the US-Dollar in comparison to the Euro currently is, become cheaper the lower the exchange rate gets.
2) Exports to countries with relatively weak currencies get more and more unattractive since the relative price-level is too high compared to domestic prices in the foreign country.

Since the US-Dollar continues depreciation, net-exports from European countries might decrease more and more towards trade-deficit. This of course raises the question if the European Central Bank should intervene with an adequate monetary policy to help exporters in the EU.

2 The European Central Bank

2.1 The objective of the European Central Bank

In principle the most developed countries have a Central Bank whose functions are broadly similar, constructing on long-termed experiences between the first Central Bank, Sweden’s Rijisbank (1668) and today’s Central Banks like the Federal Reserve of the United states or the European Central Bank. (Board of Governors 2005)

According to the Treaty of European Union, the primary objective of the ESCB¹ is to maintain price stability². It shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community (including employment, economic growth).

The objective of maintaining price stability as the primary objective of the ECB has been assigned since decades of practical experience and large numbers of economic studies suggest that monetary policy will contribute most to improve economic prospects and raise the living standards of citizens. (Scheller 2004, p.45)

Beside experiences from the past and further sophisticated arguments, price stability has 3 very obvious effects (Scheller 2004, p.46):

1. Changes in relative prices can be recognised easy since such changes are not obscured by fluctuations in the overall price level.
2. „Inflation risk premiums“ to compensate risks can be avoided
3. Stock-piling of real goods to avoid and compensate future price increases are not necessary

2.2 Instruments of the ECB and the mechanisms of action

In general the ECB as well as other Central Banks disposes over three different tools (Monetary Policies) to affect the money-supply and the value of money in the market (Mankiw 2006, pp.600-603):

1. Open market operations: The ECB buys or sells bonds from the public in the bond market to increase or decrease the available money on the market
2. The Refinancing Rate: The ECB defines the interest rate on which the ECB lends to the Banks in the Euro Area Banking Sector to influence the demand on money lent by banks and public for invest and consume
3. Reserve Requirements: The ECB regulates the minimum amount of reserves that banks must hold against deposits in order to control the effect of money multiplication

All three above listed measures do have an indirect impact on the supply of money in the market with similar implied impacts but different mechanisms of action and different time to respond.

Figure 2 (Mankiw 2006, p.613) shows the effect of increasing money supply by central bank - either caused by buying bonds, reducing the refinancing rate or by reducing the reserve requirements.

An increase of money supply will always shift the money supply curve to the right which leads to a lower value of money, or in other words prices will increase, inflation is the effect.

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Figure 2 - An Increase in the Money Supply (Mankiw 2006, p.613)

Over the long run, the economy will not be influenced in terms of its ability to supply goods and services (aggregate supply). The output of an economy is defined by other factors as natural resources, productivity, technological knowledge and further more. The money just acts as a medium to change goods and services without any meaning to the amount to be applied as long as the economy is closed against foreign trade and the inflation rate is low (see also Mankiw 2006, p.614).

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¹ The ECB is the Central Bank of the European System of Central Banks - ESCB

² Price-Stability is a matter of definition - ECB is subjected to keep Inflation <2% (HICP)