Member states of the European monetary union have enjoyed remarkable price stability since the European Central Bank was established in 1999 and took over the monetary policy making role for the signatory members of the Euro area. There is no doubt that by varying benchmarks, Economic and monetary integration is considered a success story. The transition to the different stages of Economic and monetary union (EMU) and most importantly to the final stage of the process (a single currency in 1999) was extraordinarily successful. However, there are also many points of dissatisfaction with the how monetary policy is conducted within union, especially with regards to the primary objective of the ECB’s monetary policy of prioritizing price stability over economic growth.
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With the decreasing economic growth in the Euro area, the role of monetary policy to steer economic growth and put back people to work has received much attention. The debate has become rather intense and often controversial. Policy makers and analysts alike accuse the European Central Bank of implementing monetary policy strategy that is not conducive to economic growth. Some even call the ECB monetary strategy ”anti- bias to growth” specifically because of its interest rate policy (Jorg Bibow). Indeed, there have been frequent calls for the ECB’s monetary policy to pay more attention to economic growth by stimulating aggregate demand rather than excessively concentrating on inflation targeting while depending on external stimuli for growth (Jorg Bibow, 2007). But to be fair, monetary policy in the Euro area is sometimes rigid (when the ECB anticipates inflation) and flexible (when it fears deflation). The economy has also witnessed some brief period of expansion and contraction but clearly, the rate and level of growth has not been a long term one as it is highly doubtful that the Economic outlook for the Euro area in the near future would anyway reach the level that it was in 2000, just one year after the ECB took over as the undisputable monetary policy authority for the whole of the Euro area.
Those who argue for price stability as the main function of monetary policy see stable and low price level as a precondition for a long term economic growth. Those who argue for an inclusive monetary policy contend that any effective monetary policy must take the promotion of aggregate demand very seriously and as a sine qua non for long term economic growth. In the light of this, the question then becomes; has the ECB’s monetary policy objective of maintaining price stability while rarely taking the issues of aggregate demand very seriously fundamentally creates conditions that are conducive for long-term economic growth? What factors are to be considered to determine whether monetary policy is conducive to bringing about a long term economic growth? These are some of the questions this paper attempts to answer.
The overriding objective of this paper is therefore to explore and analyse the impact of the ECB’s monetary policy in the Euro area. Specifically, we seek to assess whether the ECB monetary policy objective facilitate or impede economic growth, and examine the interaction between the ECB’s rate of interest and the main determinants of long-run economic growth such as domestic demand. In order to do that, the paper is divided into five parts. The first part is the introduction, the second part provides the theoretical framework, the third part provides a brief overview the ECB’s monetary objective, the fourth section analyses the economic performance of the Euro area between the years 2000 and 2008, and the fifth section concludes.
The role of money and the question which of the two macroeconomic objectives of monetary policy is more important: whether inflation targeting should be prioritized over economic growth (driven by domestic demand) have been hotly debated by the monetarist and Keynesian economists. In the General theory (1936), Keynes contends that slow economic growth and unemployment is primarily caused by insufficient aggregate demand (AD). For Keynes, the Central bank can indirectly influence aggregate demand in the economy through its interest rate policy. If a central bank lowers its key interest rate, commercial banks will follow suit and lowers their borrowing rate of interest, which then stimulate economic activity (i.e. spending). Increase in spending is above all good for the economy, because it increases aggregate consumption, which further increases the rate of employment since employers will likely employ more workers to increase productive capacities. This view is buttressed by (Tobin, 1978), who argues that tight or rigid monetary policy affects liquidity and banks’ ability to lend which therefore restricts loanable funds to investors and business firms thereby contracting domestic demand and investment.
On the contrary, Otmar Issing argues that, there is a general agreement among economists that money is important in the economy but the effect is only in the short run because in the long run, the effect is actually relatively insignificant as a rule (Issing, 1992:pp. 244).However, it would also be fatal, if one were to take the theoretical literature on the connection between money and growth to support the view that a little inflation could by no means harm growth (Issing, 1992:pp. 247).The only real problem according to Issing, is that the higher the rate of inflation, the greater the uncertainty about future monetary developments (Issing, 1992:pp. 247).Consequently, a lastingly high rate of economic growth cannot be achieved through a passive monetary policy which tries to keep central bank interest rates low (Issing, 1992:pp. 250). Thus, it will be useless for a central bank to lower its key rate of interest in order to stimulate economic activity because any change in the monetary supply (either increase or decrease) will result in a change in the real value of money. Describing this transmission mechanism, monetarists argue that, because inflation is always a monetary phenomenon, any increase in the level of money supply will always lead to a proportional change in the price level of goods and service. In fact, “while there is a temporary trade-off between inflation and unemployment, there is no permanent trade-off” (Milton 1968, p.11). In other words, a change in the money supply can only influence economic outputs in the short run, but in the long-run it only influence the price level in the economy. For all intents and purposes, what monetary policy can do is that it can prevent money itself from being the source of major disturbances (Milton 1968, p.11). This negative component of monetary policy can only be controlled if the central bank fixes a rate of money supply; Friedman recommends an annual growth of monetary supply in the range of “3 to 5 percentage” (Milton 1968, p.16). Clearly, the overriding target of monetary policy for the monetarists consists of keeping the price level in the economy as low and stable as possible because low and stable price level will somehow; provide the optimal environment for long-term economic prosperity.
The Monetary Policy of the ECB’s and the Issues of Aggregate Demand
In line with Friedman’s assertion that Inflation is always and everywhere a monetary phenomenon, one of the main goals of Central Banks throughout the world is to keep inflation under control, ”which usually means keeping a steady, low rate of inflation” (Richter and Wahl,2011:pp.5). Not being an exception, the primary objective of the European Central Bank is to keep price stability in check, while other targets (such as economic growth and employment) can be considered as long as they do not violate the primary objective over the medium term. Price stability is then defined by the Governing Council of the ECB as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of “below, but close to, 2 per cent in the medium term” (ECB, 2011: pp. 64). To achieve its objective, the ECB targets not only inflation, but also the monetary supply in the economy at the rate of 4, 5 % per year. The combination of the price stability objective and the monetary target objective is known as the two pillar strategy of the ECB (ECB, 2004:pp.10).
The ECB’s price stability mandate has often been weighed against that of the multiple objectives of the U.S. Federal Reserve who is legally required to contribution to aggregate demand (Labonte and Makinen 2008:pp2) by maintaining the growth of the monetary aggregates proportional with the economy’s long term potential to encourage demand and increase production, so as to effectively promote the objectives of full employment, stable prices and modest and reasonable long-term interest rates. (U.S. FED Act, Section 2A, 12 U.S.C. 225a). It is therefore clear that the US FED monetary policy is conducted in such a way that aggregate demand is taken seriously, and the practical consequences of this monetary stance will be highlighted in the fourth section of this paper.
What role does aggregate demand play? Why is the US Fed so keen on maintaining the (AD) in the economy? In answering these questions we may however, be forced to return to the basic of (AD). Gordon Ruby defined demand as the measure of the ability of households to spend or the level of expenditure necessary to command varying quantities of goods and services at different price levels (Ruby, 2003:pp.1). The relationship between the price level and the amount of real GDP demanded is negative because; when the price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases in the same proportion (McConnell, 2008:pp.225). But when the price level rises, consumers would need more money for consumptions, and business owners would need more money to invest in new technologies. An increase in price level increases the demand for money, and because the supply of money is fixed, an increase in the demand for money will always drive up the price paid for its use. The price of money is therefore the rate of interest (McConnell, 2008:pp.226).
Practically speaking, a change in the central bank’s interest rates influence other interest rates, principally, those set by commercial banks on short-term loans and deposits. In addition, anticipations of prospective key interest rates also affect long-term market interest rates. This led the ECB to declare in 2004 that ”at the end of the day, price control and economic stabilization is complex and the ECB’s focus in only trying to maintain price stability seems reasonable when looking at the many entangled transmission process through which the ECB’s open market operations flows.(The ECB,2004:pp. 45-48). The ECB maintain its mandate of price stability by increasing the rate of interest when the level of inflation is more than the target, and cuts rate of interest when it is below the target. Increase in the rate of interest will encourage consumers to consume less, since the incentive to save money is high (due to high interest rate). As a consequence, the money supply in the economy will be drastically reduced which then leads to stabilized price.
This led Bibow (2007) to brand the ECB key interest rate policy as ”anti-bias to growth”. For Bibow, higher interest rates restrain consumption which in turn, restrains investment. For example, consumers may decide not to invest in a new stock, in the real estate or even to buy a vehicle when the cost of borrowing is high. Consequently, increasing the demand for money and the interest rate will lead to a higher price level which reduces the amount of real output demanded (McConnell, 2008:pp.226). A reduced interest rate during a period of economic downturn on the other hand is more conducive to economic growth because it makes it easier for households to borrow at a modest rate of interest. The implication of this kind of interest rate policy will result in an increase in domestic consumption which is the main engine of economic growth. Indeed, of all four components of aggregate demand (Consumption, Investment, Government expenditure, and the differences in export and import), consumption expenditure is the largest contributing to between 60% and 70% of total expenditure (Ruby, 2003:pp.1).Increase in consumption will result in firms being more confident to borrow ( at a low rate of interest) and invest in new technologies and therefore hire more workers to increase production just by the expectation that there is a buoyant demand for their goods and services. This is exactly the reason behind the US Fed obsession with maintaining the level of (AD).
Looking back: the ECB’s performance from 2000 to 2008
The Euro area economic performance and emerging pattern of brief upswings, drawn-out stagnation, and overly reliance on external growth are not only the opposite of the US situation (characterized by long domestic demand driven upswings and brief downturns), but much resemble Germany’s patter of the past (Bibow, 2007: pp.303).It is important to note that, the management of domestic demand is left to the ECB alone, mainly due to the unique Macroeconomic arrangement of the Euro area where member states are strictly constrained in the use of fiscal policy to counter asymmetric shocks (Bibow, 2007: pp.303).
Figure 1: GDP growth rate in the Euro area (in %)
Source: Bruegel, 2008
As can be seen from figure 1, the economic growth statistics for the Euro area appears to be less than satisfactory. Economic growth fell from an annual rate of 3.9% in 2000 to 0.9% in 2002, before recovering to only around 2.1% in 2004 and with a further decline in 2005 to a level low of 1.3 %. Forecasts for 2006 shows increase to 1.9 % and 2.1% in 2007. In contrast, as can be seen from figure 1.1 below, real GDP growth rate in the US in 2002 was 2.45 % compared with the 0.9 % in Europe during the same time.
Figure 1.1: GDP growth rate in the United State (in %)
Source: indexmundi, 2011
The Euro area was the only major region in the world that did not participate in the global economic prosperity that started in 2002 after the dot-com bubble burst in 2000 which brought the global economy into a severe economic crisis (Bibow, 2007 pp. 302). While it took the other regions of the world (including deflationary Japan) to recover from the crisis, it was not until 2006 that the Euro Area began to show a sign of what seem to be a weak recovery after five years of protracted stagnation. In a global economic climate characterized by growth enthusiasm, the economic outlook of the Euro area was rather unsatisfactory (Bibow 2007, p.310).But how is it possible that the Euro area completely failed to participate in this global boom as well its slow and uneven recovery? From this perspective, Jörg Bibow blames the ECB’s monetary policy for this unsatisfactory economic performance (Bibow, 2007 pp. 302), when he argues that the ECB key interest rate was frequently set too high and thus usually out of touch with markets and economy; figure two exemplifies this hypothesis. Bibow has characterized the period starting from the years 2000 to 2005 as a period of drawn out stagnation where the ECB key policy rate has been habitually out of touch with the final domestic demand as a contribution to GDP growth.
Figure 2: Asymmetric and out of touch with markets & economy
Source: (Bibow, 2009)
As can be seen from figure two, there is always a negative relation between increase in the rate of interest and decrease in the percentage of domestic demand growth. For example, when the ECB rate of interest was at 2.4 % in 2000, the domestic demand growth was 3.5 %. But when in 2001, the rate of interest was increased to almost 5 %; the domestic demand growth took flight to a level low of 1.1 %, and 0.0% in 2002. A somewhat moderate recovery took place in 2006 and 2007 at 2.5 % and 3 % respectively. The recovery was mainly as a result of the cut in the rate of interest to 2.11 % in 2004 and 2.19 % in 2005 which then brings ECB key interest rate in line with the final domestic demand. It is clear that the development between 2004 and 2005 laid a conducive foundation within which the positive economic outlook in 2006 and 2007 (a period of the so called export driven ”Goldilocks recovery”) could be established. This makes one wonder whether the ECB has learnt from its previous out of touch interest rate policy, and now recognizes the importance of low interest rate policy for economic grow. But this is obviously not the case because as the figure shows, the ECB in anticipating this recovery again, increased its key interest rate at the beginning of 2007 and to all level high of 4% in 2008 which then drives domestic demand growth to an all-time low of -2.5% in 2009.
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It is easily noticeable that the moment the ECB increased its key interest rate; there is a sharp fall in the final domestic demand which then causes the ECB key interest rate according to Bibow to lose its touch with the economy and market. It is not difficult to spell out the economic consequences of such an out of touch interest rate policy: the higher the rate of interest, the less firms are willing to loan money from the commercial banks which then means that there will be less investment and consequently, a lower rate of economic growth in the economy. For that reason, the ECB performance in the first few years of its operation is a rather poor one. Comparatively high interest rates combined with somewhat low growth rates – compared with the US and Japanese growth enthusiasm was rather disappointing.
Figure 3: Short-term interest rates (annual average in %)
Source: Eurostat, 2012
As figure 3 above shows, Between January 3, 2001, and June 25, 2003, the target rate for federal funds was reduced to 1.22% from 3.7%. This policy was reversed in 2005 in 2006, the rate of interest was raised to 5.20 % but GDP growth remained at 3.2%. No additional changes were made until 2008 where the interest rate was reduced to 2.91%. These reductions were designed to ease credit market conditions and stimulate spending (Labonte and Makinen 2008:pp2).
It is interesting to see the relationship between rate of interest, domestic demand and the growth of GDP. For example, in 2002, the ECB’s interest rate was set at 3.32 %, with the rate of domestic demand being at 0.0% and real GDP growth rate of 0.9%. Within the same time frame, the FED sets its interest rate at 1.79 (as figure 3 shows) and enjoyed a GDP growth rate of 2.45%. Thus, in contrast to the ECB which favours price stability over economic growth, the US Federal Reserve system is friendly and accommodative to economic growth. As the figures above show, in period of harsh economic conditions, the Fed has acted in a timely fashion by cutting interest rates in order to promote domestic consumption and investment. From third quarter of 2003 to the third quarter of 2006 the ECB’s monetary policy did not hinder the economic growth potential of the Euro area because it did not change its key interest rate as it did in the period between 2000 and 2003, but this is not to say that the ECB’s monetary policy strategy and economic performance was anywhere near satisfactory.
Throughout the paper, it has been shown that the ECB’s monetary policy objective of price stability is not conducive to economic growth because its key interest rate policy is only but a tool to achieve price stability and deflationary risk. The analysis has revealed that the ECB sometimes implement expansionary monetary policy when it fears deflation, by cutting interest rate (like it did in 2004 and 2005), and some other times, it implements a contractionary monetary policy when the level of inflation in the economy appears to be above its targeted rate, by increasing its key interest rate (like it did in between 2006 and 2008). This asymmetrical policy orientation where domestic demand is not taken seriously but merely used as a tool to achieve the key objective of price stability had laid the foundation within which the Euro area effectively became an Island of stagflation from 2001 onwards. Rather than decreasing the key interest rate in order to stimulate economic activity in order to help the crisis ridden Euro area out of the harsh economic conditions in 2001, the ECB instead increased its key interest rate to 4.26 %. The consequences were clear: domestic demand fell from 3.4 % to 0.0% in 2002.
It has been argued here that the ECB’s monetary policy strategy is strongly characterized by assumptions provided within the quantity theory. It is thus not astonishing that the ECB used its independence to clarify its main objective, namely price stability, by fixing a money supply rate. Throughout this analysis it becomes obvious that the ECB is inflation phobia and has prioritized price stability over any other macroeconomic objectives such as domestic demand driven growth and high level of employment. A closer look at the ECB’s key interest rate policy and domestic demand growth in the last ten years highlights more serious deficiencies.
Answering the guiding question of this paper, it can be argued that the ECB set the key interest rate frequently too high and thus in fact jeopardized a proper economic growth in the Euro area in contrast to the US Fed’s monetary policy geared towards maintaining a high level of domestic demand during the years under study.