The relationship between the money supply and the inflation rate and the role of the European Central Bank in changing the money supply

Content

1. Introduction

2. The Relationship between Money Supply and Inflation Rate in the European Union
2.1 The Effect of an Increase of the Money Supply
2.2 The Effect of an Increase of the Price Level
2.3 Moulding Money Supply and Price Level together
2.4 The Data
2.5 Conclusion

3. The Role of the European Central Bank in Changing the Money Supply in the Euro Area
3.1 Controlling the Money Supply via the Money Multiplier and the Required Reserve Ratio
3.2 Controlling the Money Supply via the Monetary Base
3.2.1 The Discount Rate
3.2.2 Open Market Operations
3.2.3 Foreign Exchange Market Operations
3.2.4 Standing facilities
3.2.5 The Composition of the Monetary Base
3.3 Conclusion

4. Bibliography

1. Introduction

This essay consists of two topics, both belonging to the field of money supply in the European Union (EU) since the introduction of the Euro 2002.

The first part examines the relationship between money supply and inflation rate. Illuminating this relationship, it also explains the monetary policy of the European Central Bank (ECB). The link between its policy and the relationship of money supply and inflation rate will be highlighted by using graphs and current data. The first part ends with a critical view upon the policy of the ECB and the theories regarding the money supply.

The second part deals with the role of the ECB in controlling the money supply. It shows which tools central banks have in general at hand to control the money supply, followed by an explanation of how these tools work. Finally, it discusses the development of the ECB and the steps it takes to control the money supply efficiently.

2. The Relationship between Money Supply and Inflation Rate in the European Union

According to article 105 of the EC treaty the primary objective of the ECB is the stability of price levels, which has been defined by the board of the ECB as an increase of the harmonised index of consumer prices (HICP) of less than two percent (ECB Monthly Bulletin, January 1999). This shows that the most independent central bank in the world (Bofinger, 2001) also has the most ambitious objective in the world (Heine & Herr, 2004).

Since the immense independence enables the ECB to freely choose a way to reach their goal, the board decided to follow a strict expansionary monetary policy. So the ECB strives for an annual increase of broad money M3 by four and a half percent (ECB Monthly Bulletin, January 1999).

The reasoning and what the economical mechanisms are leading to this decision will be discussed in the chapters to come.

The two following assumptions, which apply to the EU, are underlying to all of the subsequent models:

- The existence of monopolistic trade unions and
- the existence of flexible exchange rates.

2.1 The Effect of an Increase of the Money Supply

According to the money market model of Case and Fair (1999) an increase in the money supply (Ms) at equilibrium causes a decrease of the interest rate (r), because more money is supplied, than needed. Thus households will deposit their exceeding money at a bank, trying to benefit from the high interest rate of interest-bearing bonds. Following this increasing supply of money, pressure is put upon the interest rate, which drops until new equilibrium is reached at a lower interest rate.

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As the interest rate is the price for borrowed money, it causes capital to be available at better (cheaper) conditions. The interest rate's decrease causes the demand for loanable funds to be higher. (Mankiw & Taylor, 2006).

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The result of the rise in loanable funds at a lower interest rate is an increase of planned investment (I) and, as I is a part of planned aggregate expenditure (AE), AE increases as well. An increase of AE causes equilibrium aggregate output/income (Y) in the goods market to increase. The result is a shift of the IS curve to the right, which is displaying the negative relationship of the interest rate and aggregate output/income in the goods market (Case & Fair, 1999).

But the LM curve is displaying the positive relationship between the equilibrium value of the interest rate and the Y in the money market. At any point of the LM curve the demand for money equals the amount of money supplied. If the money supply increases and the interest rate drops, the LM curve shifts to the right.

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Under those circumstances expansionary money policy results in an increase of aggregate output/income. The effectiveness, however, strongly depends on the reaction of investment to the change in the interest rate. If investment does not increase sufficiently even with low interest rates, the effect of expansionary money policy is but small (Case & Fair, 1999).

2.2 The Effect of an Increase of the Price Level

As shown in chapter 2.1 firms are investing, when loanable funds are available at affordable rates. Thus firms hire more workers, to increase production.

But as workers in the EU are represented by powerful monopolistic trade unions, higher demand of labour leads to higher wages, which means costs of production increase, while productivity remains unchanged. The result are increasing prices (Case & Fair 1999, Mankiw & Taylor, 2006).

From this evidence a vertical long-run aggregate supply (AS) curve is derived, which is showing the total supply of services and goods produced in an economy (see figure 5).

If the price level increases, the demand for money rises. Since the same amount of money has less value, one needs more of it to buy the same amount of goods and services. The direct consequence is a reduction of the real money supply, shifting the LM curve to the left.

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Due to this effect, the IS curve must also shift left, which means income must fall.

As income is a function of AE, income falls when either one of AE's components consumption, planned investment, government spending or net exports falls. Planned investment, depending on the interest rate, stays unchanged as does government spending.

Through the reduction of real money supply consumption decreases also known as the real wealth effect. Additionally, AE is reduced by net exports. Net exports are a function of the real exchange rate. The real exchange rate composed of the exchange rate times the world price divided by the national price. If national prices rise, the real exchange rate falls. This means domestic products are less competitive, which leads to a fall in exports, thus income.

Resulting from this the IS curve shifts to the left, due to the fall in net exports and the impact of the real wealth effect (Case & Fair, 1999). Adding the horizontal foreign exchange (FE) curve, which displays the interest rate of the national economy with flexible exchange rates, figure 4 is drawn. The result shown in this figure is a decrease of Y.

The negatively sloped aggregate demand (AD) curve can be derived from this relationship, showing that an increase of the price level reduces income.

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