Economics Of Euro

Introduction, historical background

Institutions, budget

Decision-making

1. Who should be in charge of what? Principle of subsidarity, Brexit as a result of ’taking back control'.
2. Is the EU-level decision-making efficient and legitimate? Scale of exclusive to shared to national competences. Exclusive: monetary policy, customs union, common commercial policy.

The Council adopts legislation by qualified majority voting (based on Lisbon Treaty). This acheives balance between the union of staets and union of peoples to have democratic legitimacy in the EU’s decision-making process. EU Parliament adopts laws by simple majority.

Costs of a common currency

Mundell I

Monetary union will be costly if wages and prices are not flexible, labour is not mobile across borders.

De Grauwe

Amplification

Consider country in monetary union hit by negative demand shock. This leads to smaller output and decline in employment. This means as GDP decreases, tax revenue decreases. Secondly, as unemployment increases, government expenditure increases. These two effects together lead to government budget deficit increasing. This is automatic and inherent in the government budget. If aggregate demand shock is strong enough, the ensuing automatic increase in government budget deficit can become so large that investors start having doubts about the solvency of the government. This leads investors selling government bonds, bringing interest rates up and causing liquidity crisis. The aggregate demand curve \(D’\) shifts further to the left, ending up with aggregate demand curve \(D’’\) (because with higher interest rate, people will spend less on consumption and investment goods). These interest rate changes, instead of stabilizing the system, tend to destabilize it. All this intensifies the adjustment problems of both countries.

If country were outside monetary union, then to switch to another country’s government bonds, one has to go through foreign exchange market. This means that currency has to depreciate and this actually leads to increas in competitiveness and shifts aggregate demand right, being stabilizing force.

The Covid-19 pandemic: Asymmetric effects of a symmetric shock

In 2020, world was hit by Covid-19 shock. As result of pandemic, supply chains were disrupted and this lead to loss of incume of millions of people and capacity to spend decreases. A deflationary spiral was set in motion whereby the less of output led to less demand, which in turn reduced output and so on. Negative supply shock led to negative demand shock.

This same shock had different effects on different countries in EMU. The stronger the drop in GDP, the higher the increase in budget deficits. This increases, as earlier described, a risk of future self-fulfilling liquidity crises. Governments are forced to introduce budgetary austerity, exacerbating recession.

White IS-LM model, affected sector had output forcible constrained and demand collapsed and in non-affected sector, no supply contraint, but demand fell due to income loss and precautionary saving.

The theory of optimum currency areas: A critique

Relevance of asymmetric shocks

EC vs Krugman

Effectiveness of national monetary policies

Permanent shocks

Inflation (Balassa-Samuelsson)

We have assumed equal inflation, because due to relative purchasing power parity, in monetary union, inflation should be equal. But this is obviously not a case. This can be explained by the Balassa-Samuelson effect. \[ \begin{aligned} \dot p_{A}-\dot p_{B}&=(\alpha\cdot \dot p_{TA}+(1-\alpha)\cdot \dot w_{A})-(\alpha\cdot \dot p_{TB}+(1-\alpha)\cdot \dot w_{B})\\ &=(1-\alpha)\cdot (\dot w_{A}-\dot w_{B})=(1-\alpha)\cdot (\dot q_{A}-\dot q_{B}) \end{aligned} \]

Mundel II

Credibility (Barro-Gordon)

Consider Philips curves \(U=U_{N}+a(\dot p^e-\dot p)\) and indifference curves of monetary authorities. Under the assumption of rationality, short-sighed authorities that e.g. announce that they will follow a monetary policy rule of keeping the inflation rate equal to zero. Then, we arrive at point \(A\), however notice that authorities can do better than point \(A\), i.e. being at point \(B\) by cheating infliation unexpectedly. Thus during the next period, the Phillips curve is likely to shift upwards and from \(C\), following same logic, we after series of iterations arrive at point \(E\).

Supplement on fiscal policy: Passive vs. active demand stabilization policy

Counter-cyclical fiscal policy may be a corrective device to keep unemployment at its equilibrium level, and output near its trend growth path. This entails expansionary fiscal policy when economy is in recession and contractionary fiscal polict when economy is in expansion. On trend, we have fiscal policy, which would generate an actual budget surplus at point \(A\). Endogenous shocks, like falling into recession would lead us to point \(A’\). The positive slope of each schedule represents the automatic stabilizer: given tax and spending rules, an increase in the GDP improves the budget balance automatically. Now, when new looser budget is approved by parliament \(FP’\), the fiscal policy shifts down, is more expansionary: for any given GDP level, the surplus is smaller because of either more spending, or less taxes, or a combination of both.

Using the exchange rate for stabilisation purposes may be costly, because it creates inflation and inflation is costly. Only full MU provides the required credibility.

The benefits of a common currency

Elimination of transaction costs

The EC has estimated the gains from elimination of transaction costs as €13-€20 billion a year. This represents a 0.25-0.5% of EU GDP. These benefits arise not only from same banknotes, but also integrated payment system (TARGET2).

Price transparency

The introduction of the euro should lead to more price transparency, which leads to increase in competition, leading to lower prices facing customers. In practice, however, price convergence has not happened in Eurozone, while it converged somewhat prior to the start of Eurozone. Price convergence is due to as retailers are mostly national (this explains similar prices within countries but diverging prices between countries). Therefore, price convergence is not due to price transparency due to euro, but rather euro pushes for financial integration and integration in other areas leading to price convergence.

Welfare gains from less uncertainty

Exchange rate uncetrainty and economic growth

The argument that the elimination of the exchange risk will lead to an increase in economic growth can be made using the neoclassical growth model. In a monetary union, exchange rate uncertainty is eliminated, thus systemic risk decreases and leads to lower real interest rates. This will boost investment and will put the economy on a higher growth path. Empirically, there is very little evidence that the euro has boosted growth. Therefore, the reduction in exchange rate uncertainty does not necessarily reduce the systemic risk. William Poole had put up following argument that fixing interest rate (exchange rate) does not necessarily reduce volatility of output compared to fixing the money stock.

Trade

Monetary union could increase trade among the members of a monetary union due to exchange rate certainty and transaction costs. Empirically, however positive effect of monetary unions on trade is weak.

Benefits of an international currency

Additional revenues, more investment and debt issuing by foreign residents. Political tool. Easier budget financing as foreigns hold government assets in reserves.

Costs and benefits compared

The fragility of incomplete monetary unions

First, what is incomplete monetary union? Well, we consider two types: fixed exchange rate system of pegged and monetary union that is not a budgetary union.

Peg

In this case fragility is two-fold: for one, there is credibility problem. Authorities of country promise to hold exchange rate fixed, but of course, if the benefits to deflect outweigh the costs, then promise is reneged. The other side is that foreign currency reserves are of limited size, which causes great concern to keep it fixed if domestic currency has deprecionary pressure. These interect with one another. Limited foreign reserves reduce credibility, which in turn can lead to speculators selling domestic currency, forcing depletion of domestic foreign reserves.

Following simple model catches the essence of this fragility. On horisontal axis, we set size of shock (i.e. size of deficit of current account) and on vertical axis, we set benefits and cost of breaking fixed currency exchange (breaking the peg). Let us describe plotted functions. Firstly, cost of breaking \( C \) is independent from the size of the shock due the loss of credibility. Functions \(B_{E}\) and \(B_{U}\) describe benefits function of breaking, where the former represent the structure when investors expect the break. It is worth noting that both functions are obviously increasing and when devaluations is expected, interest rate parity implies increase in domestic interest rate, which causes output to fall, thus there are more benefits of breaking the peg, giving \(B_{E}\) being above \(B_{U}\). In case of \(\varepsilon_{1}<\varepsilon’<\varepsilon_{2}\), we get two possible equilibrias \(N\) and \(D\). This in fact highlight the fact that the speculation and market sentiment alone can decide whether fixed peg breaks or not.

The condition that authorities have limited foreign currency reserves implies the possiblity of speculative attack. Otherwise, \(B_{E}\) and \(B_{U}\) coincide. Noteworthy is that evaluation is still possible in this case, but devaluation happens at the will of authorities and not investors, which can happen if cost-benefit analysis proves benefical for large enough shock \(\varepsilon_{2}\).

To reduce the fragility, simple way to increase cost structure \(C\), so that shocks do not entice the breaking from the peg.

MU

In montary union, we do not have to worry of exchange rate fluctuations, because countries share a currency. Yet, in incomplete monetary union, countries do not share budget and debt, thus budget default is a risk and this we examine now. In similar way to peg system, in this case we map on a horizontal axis the size of a solvency shock (due to decline in government revenues and recession), which we call solvency shock, while keeping vertical axis the same of reflecting benefits and costs of defaulting on debt. In same way as previously, cost is indepedent of the solvency shock, and \(B_{E}\) lies above \(B_{U}\), because when investors expect default, they sell bounds, increasing bond yields and thus increasing interest rates, which raises budget deficit, requiring austerity programmes, which makes defaulting more attractive. In case of \( S_{1} < S’ < S_{2} \), we have again the two equilibrias \(D\) and \(N\) and this means that what matters is investor sentiment whether government is forced to default or not.

To reduce the fragility of a monetary union, again increasing \(C\) helps, yet does not eliminate the risk. The next step then really would indeed be to have central bank as lender-of-last-resort or issuing common debt instead of national debts (creating budgetary union).

Banking crisis

Problems with sovereign debt can carry through domestic banking sector. This is due to two reasons, if investors pull out from bonds, prices fall and this creates losses for domestic banks who are also holders of government bonds. Secondly, they also face funding problem, because domestic liquidity dries in this case, which means the need for higher interest rates to get funding. This can lead to doom loop (or called deadly embrace), where one affects another and vice versa. This link can be broken however, through the use of banking union, which spreades the cost of a banking crisis in one country over whole country.

Automatic stabilizers

The bad effect of bad equilibrium is also forcing automatic stabilizers to close down. This is due to that recession leads to budget deficit, increases market sentiment worsening and thus liquidity worsening and risks of solvency crisis, and to find cash, government has to do decrease spending or increase taxes.

The transition to a monetary union

The first example of european monetary integration was Latin Monetary Union in 1865 between France, Italy, Belgium, Switzerland. The system consisted of accepting each others currencies as forms of payment and using silver-gold coin system. This lead to only gold being used due to Gresham’s law and union failing as country were independent enoguh to print money which other countries had to accept as form of payment. De facto system collapsed with the eruption of WW I, while de jure it was ended in 1927.

Interwar period was inward turned, while after WW II again monetary integration began. While Bretton Woods system was established in 1944, it only came into effect in 1959 with the establishment of European Community. Before that, in 1950-59, European Payment Union ruled where surplus countries received gold payments from deficit countries. From 1959, the system was that European currencies were pegged to dollar and dollar itself was pegged to gold. This ended in 1971/73, with 70s experiencing large exchange rate variabilities, and thus in 1979 EMS was founded, which consisted of ERM and ECU. ERM entailed adjustable peg system. Yet, EMS failed to fix exchange rates without common monetary and economics policies, which led to conclusion that there are only two workable systems: flexible rate system or monetary union. The monetary union was codified in 1991 with Maastricht Treaty. Indeed, euro (which was equated with ECU) was created in 1st of January 1999 with only 1st of January 2022 banknotes and coins going to circulation.

The Maastricht Treaty

The Maastricht Treaty in 1991 set out how EMU should look like. In fact it was based on gradualism and convergence. Convergence included

1. inflation rate not more than 1.5% higher than average observed in lowest inflation rates among EU members
2. long-term interest rate not more than 2% higher than average observed in these three low-inflation countries
3. part of ERM of EMS and no deflation two years before joining MU
4. government budget deficit not higher than 3% of GDP
5. government debt not over 60% of GDP.

It is worth noting that The Maastricht Treaty does not take the approach of OCA, where labour mobility and labour market flexibility were according to this theory conditions for succesful MU, together with arguing for budgetary union. These microeconomic and political conditions seem to go against The Maastricht Treaty macroeconomic conditions (inflation, interest rate, budgetary policies). In fact, these were chosen for political reason, to make MU attractive for everyone, to even have a MU.

Inflation convergence was set out to ensure that low inflation countries did not suffer from being in monetary union as this tends to increase if inflation preference are not same. Budgetary convergence was set out to ensure that high-debt countries would not force low-debt countries to more inflation through creating surprise inflation to lower the value of long-term debt. This is not to say that high-debt countries cannot form monetary union, but that allowwing these countries to union increases the risk of more inflation in the future EMU, therefore debt and deficit reduction prior the entry has been laid out. Exchange rate convergence was set out to prevent country depreciating its currency to gain more competitive position. Interest rate convergence was set out to avoid large capital gains and losses at the momeny of entry into EMU.

How to complete a monetary union

Completing monetary union generally entails political union. It is clear however that a ‘deep variable’ of sense of common destiny and belonging is missing in Europe, therefore following US or jumping into large centralization is not reasonable. Nevertheless, smaller steps towards it can be maken.

We identified problem that markets drive governments into bad equilibrium. This can be solved by collective action aimed at steering countries towards good equilibrium. Collective action can be taken at two levels: at the level of central banks and at the level of the governments. The former is to deal with crisis situations and the latter as structural strengthening of the union.

Central bank as a lender-of-last-resort

Liquiduity crises are avoided in stand-alone countries that issue debt in their own currencies, mainly because the central bank can be forced to provide all the necessary liquidity to the sovereign.

Similarly, central banks have responsbility as lender-of-last-resort in banking sector. Since banks borrow short and lend long, bank run causes illiquidity for banks, which may lead to banks trying to find cash and selling assets, leading lower asset prices, leading to in turn solvency crisis. The nice feature is that when deposit holders are confident that the central bank will exert this function they will rarely run to their banks, so that the central ban rarely has to step in to provide cash to the banks.

ECB recognized its role as a lender-of-last-resort in September 2012, when it stepped in and committed itself to buying unlimited amounts of government bonds in times of crises. This programme is called ‘Outright Monetary Transactions’ (OMT) in EU.

Risk of inflation

Criticism against active role of central bank of monetary union being lender-of-last-resort is that this would lead to inflation. This criticism can be countered by two points. Firstly, there is distinction between money base and money stock. ECB increases in this case money base, but money stock does not increase necessarily. With money multiplier decreasing, this means banks hoard this liquidity and they themselves do not use their cash to expand bank credit. As a result, the money stock (M3) does not increase much, despite the massive increase in the money base. Secondly, with financial crisis, we have recession and agents scramble for money. This deflationary process is stopped by central bank supplying more money base.

There is however risk of inflation in the future when the economy starts booming again. The central bank can then withdraw the liquidity by selling government bonds or by increasing minimum reserve requirements of banks.

Fiscal consequences

Moral hazard

Consolidating government budget and debts

Second building block in the completion of monetary union is budgetary.

Political economy of deconstructing the Eurozone

EU Treaties do not have no exit clause. Nevertheless, possibility of leaving Eurozone exists, case studies of Greece and Italy in the context of 2008 crisis provides some reasoning.

What happened in Greece was following. Before 2008, Greece was booming, yet deficit increased from 99% of GDP to 103% of GDP in period of 1999-2008, which meant that Greece conducted pro-cyclical fiscal policies in period of boom, while it should have run surpluses. On top of that, private financial sector borrowed cheap money from the north of EU and this caused unit labour requirements increasing, causing lost of competiveness in Greece. On top of that, with Greece suffering from excessive debt, financial markets pulled out from government bonds, increasing bond yields and taking their money outside of Greece, causing also liquidity problems, forcing austerity. This forced Greece to do internal devalution (as monetary union implies currency devaluation is not possible), which was quite prolonged and furthermore as Greek government cannot issue its own debt, it is reliant on other creditors and ultimately suffers of sovereignity as was case of forced austerity from Eurozone’s creditors.

In Italy, things were different. Italy had problems with producivity, while unit labour requirements remained, it had declining producitivy, thus losing in competiveness. Italy has not done internal devaluations and has seen stagnent or no growth since the start of Eurozone in 1999.

These cases highlight that lost of competiveness was part of difficulties, which was further caused by the fact these northern creditor countries did not carry internal revaluation (wage increases) through its fiscal stimulus programmes (case of example was Germany holding unit labour costs flat until 2015).

Therefore, it is important to consider the possiblity of leaving the Eurozone and exit costs. Firstly, with say Greece leaving, euro-deposits going out of Greece to Eurozone, because if they stayed there, they would be converted to Greece’s local currency, drachmas, which are likely to depreciate against euro. Secondly, Greek government will likely (partially) default on its debt, which leads to losses in local banks, holding government bonds, leading to withdrawal of deposits. This total banking crisis leads to recession. And even this recession might be so severe, that it might lead to social unrest and eventually leaving EU. Of course, there is also possiblity of recovering from recession (through devaluation of the drachma) and eventually functioning again normally, yet outside Eurozone, but in EU.

The effect on the rest of MU can go either way. In optimistic scenario, according to OCA, Eurozone moves closer to OCA-line and actually this dramatic exit leads to even more closer cooperation to avoid future such scenarios. In pessimistic scenario, one exist might lead to question the permanence of the MU and lead to redomination, i.e. banks matching their assets and liabilities within countries, hurting financial integration within the union. This leads to pushing Eurozone away from the OCA-line.

The European Central Bank (ECB)

While most member states upon joining EMU had Anglo-French model for the functioning of the central bank, German model prevailed. This was due to prevalence of monetarist thinking and Germany’s special position to join the EMU, which consisted of Germany’s insistance of low inflation target.

When comparing ECB with FED, one can make case that ECB is a conservative compared to the FED. This is reflected through smaller variance of interest in ECB compared to FED, while mean interest rates was same in the period of 1999-2021. Also, empirically, ECB attaches less weight on output stabilition compared to FED. Cautiousness to intervene is also shined through QE programmes as ECB stepped in later and with lesser extent providing liquidity.

The independence and accountability is another factor to consider. Of course, these two factors should be positively correlated. Yet, several analysis conclude that ECB is the most independent central bank, which means that accountability should also be higher. Yet, this does not seem to be case, because accountability in treaties is vague and change of treaties requires unanimity of all EU members, while in FED, Congress can change statues and thus also hold FED more accountable as well.

The vagueness of the treaty is in fact so vague that precise definition of price stability is missing and other objectives that ECB has to fulfill provided price stability are not defined either. This is interpreted by ECB that they are concerned with only price stability (whatever that can mean) and effectively also reduced its domain of responsibilities.

To reduce this paradox, ECB itself could step in and provide informal accountability in the form of transparency of objectives, instruments, and decision-making. This practically means announcing expected inflation targets, unemployment targeting and with it explanation why something failed, together with publishing minutes of the ECB meetings in its entirety (as BoE provides). Press conferences and Monthly Bulletins are not sufficient if FED and BoE are more accountable and less independent.

Structure of Eurosystem

The Eurosystem is governed by Governing Council and Executive Board of ECB. In the former, which comprises of 20 NCB presidents and the Executive Board, decision are made. ECB’s Executive Board of 6 members implements the decisions on the monetary policy, among others providing policy suggestions to NCBs.

It should be noted that with 20 NCB Governors and only 6 members of Executive Board of ECB, national interest might prevail. This has lead that small countries might going against the general good of Eurosystem, which means that with enlargement processes, on January 1, 2015, the rotating system was adopted, such that only fifteen governors have voting rights and these are rotated in two groups. First group consists of Germany, France, Italy, Spain, the Netherlands and between them is distributed 4 votes, thus these countries participate in the voting mechanism 80% of times. The other group consists of thus 15 memembers and between them are distributed 11 votes. The voting rights are rotated on monthly basis. Yet, still 15 governors compared 6 ECB executives is still favoring national concerns, compared to FED where FOMC consists of 7 FED executives and 5 state central bank governors. It should be therefore noted that one-country-one-vote does not hold and decision-making can take a lot of time as the Governing Council might be too large to act quickly and effectively (example includes OMT decision two years after soverign debt crisis in early 2010).

ECB as lender of last resort

The banks of Eurozone were gripped by full-scale liquidity crisis in October 2008. This developed through Lehman Brothers which defaulted on its promises to provide insurance to Eurozone banks which insured against mortage-backed securities (MBS). This lead to interbank lending collapsing, which meant banks decided to sell assets to be liquid. Yet, as banks stormed to sell assets, prices of assets fell and thus there were risks of solvency. Also, depositors pulled their money out, making liquidity problems even worse. ECB stepped in and acted as a lender of last resort (in this case for banks). In 2012, ECB made a bigger step (controversial and important) and was willing to buy government bonds to stabilize sovereign debt crisis, which caused massive spikes in government bond yields. The programm was called Outright Monetary Transactions (OMT). With this ECB showed willingness to provide liquidity to governments ‘whatever it takes’. Though it should be noted that ECB is forbidden to provide liquidity to governments directly, but it is allowed to buy government bonds.

Central Bank should function as the lender-of-last-resort only in case of liquidity problems, not in case of solvency problems. - Bagehot doctrine

The problem with this doctrine is that it is difficult to distinguish between illiquidity and insolvency and even if it were possible, financial markets solve the problem themselves, making CB futile as lender-of-last-resort.

The programme of OMT however is nothing light. It requires requesting government to subject themselves to several reforms, including austerity. While it makes sense to make OMT conditional on future budget responsibility (otherwise we have moral hazard), it is argued that austerity in such a case leads to extended recession, instead of helping, worsening the situation. There is also aspects of responsibilities, as ECB and Commision intend to respectively provide liquidity and policing of moral hazard. ECB acting as moral hazard police leads to independent entity deciding on things that are governmental responsibilities, which in turn could lead to governments fighting back endangering the independence of ECB.

It is worth to note that ECB is allowed to buy government bonds in secondary markets, but it is not allowed to participate in primary market directly as this is monetary financing and against the statues of ECB’s functioning. In practice, it is quite unclear, because it could happen that one day bank acquires newly issued government bond and the next day ECB buys the bond from the bank, thus line is blurry and therefore European Court of Justice suggests ECB to wait reasonable time for it, which itself is blurry.

Towards banking union

The banking crisis of 2008 highlighted inadequacies and inefficiencies in the system, where regulation and supervision were national, while banks were dispersed and thus information was not shared and this caused banks taking excessive risk by leveagign (increasing debt-to-equity ratio). This lead to new regulatory and common supervisory framework. Here has the ECB central role.

A common regulatory framework includes European Systemic Risk Board (ESRB) operating under ECB, presided by ECB’s president, and three European Supervisory Authorities (ESAs), responsible for drafting new technical standards and issuing recommendations to national supervisors.

A common supervisory framework means that ECB’s Board of Supervisors has authority to supervise systemic banks, which are banks with balance sheet over 20% of national GDP or €30 billion (about 200 banks). Smaller banks fall under supervision of national supervisory authorities.

While a common regulatory and supervisory framework is step towards more real union, to become full banking union, there are two more steps to complete: common resolution framework and common deposit insurance. The former is to lessen burden on national governments to help out their banking system and distribute the burden to European level and today exists in some form through single resolution mechanism SRM, yet it is insufficient in funds €55 billion. In big banking crisis, this is not of help. The latter is to cut through deadly embrace, when national governments to guarantee deposits, leading itself into deficits. This common deposits insurance would spread the costs of compensating the deposit holders in one country to whole Eurozone.

Monetary policy in the Eurozone

Monetary policy is within the hands of ECB, confered by Maastricht Treaty (1992, also known as Treaty on functioning of European Union, TFEU). ECB defines and outlines its monetary policy objectives in its Monetary Policy Strategy (MPS) documents. The first such document was developed in 1998, at the start of EMU, only revised three times, in 2003, 2021 and 2025.

Initially, MPS defined price stability as “a year-on-year increase of Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%”.

With 2003 revision, inflation targeting was refined and clarified, adding second key to previous definition, with policy aim keeping inflation below, but close to, 2%. With 2021 revision, it was defined that inflation targeting would be symmetric, therefore double-key formulation of price stability was abandoned. Also, it was decided that MPS were to periodically reviewed, next to be scheduled in 2030. With 2025 revision, .

The theory of flexible inflation targeting makes a claim that by targeting inflation, it is possible not only to stabilize inflation, but also stablize output around potential output. This is possible if demand shock hits the economy. In this case, aggregate demand curve shifts left and in order to stablize the economy, lowering interest rates, bring aggregate demand curve back up, stabilizing both price and output. Things are different when the shock originate supply side. In this case, we have trade-off between inflation and output, because when negative supply shock hits, prices increase and output decreases and central bank can only impact aggregate demand curve and thus shift aggregate demand curve towards right, effectively bringing down prices, but also decreasing output even further. That’s the trade-off and ECB has made it clear in its official pronouncements, it will pursue price stability.

The Taylor rule

The Taylor rule has become a popular instrument in the analysis of monetary polciies. The central idea is that central banks react to deviations of the inflation rate from its target level. In addition, they react to changes in the output hap to the extent that they care abour economic acitivity. Formally, each central bank computes its desired interest rate using the following rule: \[r_{t}^*=\rho+\dot p^*+a(\dot p_{t}-\dot p^*) + bx_{t},\] where \(r_{t}^*\) is the desired interest rate, \(\rho\) is the long-term real interest rate (the natural interest rate), \(\dot p^*\) is the inflation target and \(x_{t}\) is the output gap.

In order for this rule to lead to a stable inflation rate, the coefficient \(a\) must be larger than one. The reason is that when the inflation rate exceeds the target, the nominal interest rate should increase by more than the increase in the inflation rate, so that the real interest rate goes up. This increase in the real interest rate is essential in bringing the inflation rate back to its target level.

Financial stability: an additional objective?

Is there a trade-off between price stability and financial stability?

Let us consider IT-driven asset bubble in the late 90s as an example for a bubble. We have massive expecations and this leads to asset prices going up, meaning easier financing for companies, leading to higher investments, bringing down the costs through productivity increase and thus aggregate supply curve shifting right. But we also have aggregate demand shifting right, since new technologies create new products and thus lead to consumers spending more. As depicted, we assume supply effect is larger than demand effect. Then, we have larger output and lower price as new equilibrium. The subsequent dynamics depend much on policy regime. If central bank pursues price stability, we see interest rate decreasing, increasing stimulus pushing aggregate demand up, yielding us to point \(C\). Monetary stimulus however leads to even more higher asset prices, risking of generating a bubble. Therefore, this suggests that there is trade-off between price stability and financial stability. Technological revolution and monetary accommodation provide cockail for bubbles.

Let us consider the bubble in housing market in 2003 and crashing in 2007-08, which is not technology driven. It was instead caused by combination of ‘animal spirits’, i.e. optimistic beliefs of investors, and excessive credit creation. A bubble is set in motion as a result of ‘animal spirits’, which raises housing prices and lower the cost of capital, leading to supply curve shift down. At the same time, the bubble in housing market leads to aggregate demand shifting right as credit increases due to banks’ balance sheets increases. With assumption that both of the effects are of the same magnitude, we have that central bank might not worry about it. However, this is worringly wrong as the expansion of output based on credit creation is unsustainable.

With both bubbles, we see that central bank focusing on price stability, it might not either pay attention to inflated asset prices (as ‘animal spirit’ bubble) or might fuel boom inadvertently (technology-driven bubble)

The instruments of monetary policy in the Eurozone

The ECB uses three types of instruments: open market operations, standing facilities (credit lines) and minimum reserve requirements.

Open market operations

Open market operations are the most important instrument of the monetary polict of the ECB. They imply buying and selling of marketable securities with the aim of increasing or reducing money market liquidity. Until 2015, ECB inject liquidity through transaction using tenders. These operations, called main refinancing operations ECB provides liquidity to financial institutions in exchange for collateral. From 2015, ECB started a programme of ‘quantitative easing’ (QE), buying government bonds in the open (secondary) market.

Minimum reserves

By manipulating reserve requirements, the ECB can affect money market conditions. For example, an increase in the reserve requirements increases the shortage of liquidity and tends to reduce the money stock.

Fiscal policies in monetary unions

While monetary unification in Europe has been realized, no significant central European budget exists. This poses the question of how national fiscal policies should be conducted in such an incomplete monetary union. There are two views about this problem. The first is based on the theory of optimum currency areas and suggests that national fiscal authorities should maintain a sufficient degree of flexibility and autonomy. The secound view found its reflection in the Maastricht Treaty and the SGP. According to this view, the conduct of fiscal policites in a monetary union has to be disciplined by explicit rules on the size of national budget deficits.

The optimum currency area view is probably overoptimistic about the possibility of national budgetary authorities using budget deficits as instruments to absorb negative shocks.

The case for strict numerical rules on the size of national government budget deficits is weak. There is little evidence that these rules are enforceable. The fear that national authorities will be less disciplined in a monetary union than in other monetary regimes does not seem to be well founded.

Strict and excessive rigidity of SGP has been critized. It makes no economic sense to subject countries to numberical limits (3 percent and 60 percent) that have no valid scientific basis. Similarly, it does not make sense to impose structural budge balance, i.e. to outlaw the issue of new debt, as a long-run constraint. Governments, like private companies, make investments that profit future generations. It is desirable that these future generations share in the cost. This is achieved by issuing debt. What should be avoided are unsustainable debt levels, not debt per se.

The argument for rules on government budget deficits

Negative spillover effects for the rest of the MU, as debt-to-GDP increases union interest rate upwards, which means that the burden of the government debts of the other countries increases.

As \(b=\tfrac{B}{Y}\implies \frac{db}{dt}=\tfrac{\tfrac{dB}{dt}}{Y}-\frac{B\cdot \tfrac{dY}{dt}}{Y^2}\), we derive relation between debts and deficits, \[ \begin{aligned} G - T + rB &= \frac{dB}{dt} + \frac{dM}{dt} \implies \\ g-t+rb &=\frac{\tfrac{dB}{dt}}{Y}+\frac{\tfrac{dM}{dt}}{Y}\implies \\ g-t+rb&=\frac{db}{dt}+b\cdot \frac{\tfrac{dY}{dt}}{Y}+\frac{\tfrac{dM}{dt}}{Y}\implies\\ \frac{db}{dt}&=g-t+(r-\frac{\tfrac{dY}{dt}}{Y})b-\frac{\tfrac{dM}{dt}}{Y} \end{aligned} \]

The euro and financial markets

The elimination of national currenccies has removed an important obstacle to the complete integration of financial markets as exchange risk eliminates an obstacle to the free flow of fianncial assets and services.

Why financial market integration is important in a monetary union?

The main reason is that it can function as an insurance mechansim facilitating adjustment to asymmetric shocks.

Let us assume we have two-country model with asymmetric shock hitting France negatively and Germany positively. Suppose also that the financial markets of the countries are completely integrated. The risk of a negative shock in one country on the income of the residents of that country is mitigated. Compared to US, Europe has a long way to go to achieve the kind of financial market integration that will help to cope with asymmetric shocks in the monetary union.

In addition, while in the USA, the US federal budget is an important instrument of regional redistribution (10% decline in US state income leads federal budget compensate 2.5% back to state experienceing a negative shock). In the Eurozone, there is no similar inter-country risk-sharing mechanism in place.

Both the financial markets and national governments are of little help in sharing the risk of asymmetric shocks across the Eurozone. The only risk-sharing mechanisms that are in place involve redistributions between different generations within the same countries.

The EC launched its proposal to create a Capital Markets Union (aiming at removing the many legal and regulatory obstacles in the bond and equity markets). However, there is one potential risk to the proposed Capital Markets Union. This has to do with the fact that great financial integration can lead to larger destabilizing capital flows during periods of financial stress, when markets panic. It follows that to work well the Capital Markets Union should be complemented by stronger public back-ups in the form of a budgetary union.