The European System of Central Banks ESCB Go to www'ecb'int

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The European System of Central Banks (ESCB)Go to
www.ecb.int click on about the ECB

• The ESCB consists of
• The European Central Bank (ECB)
• The National Central Banks of the EU. (NCBs)
  This includes the 3 non-participants in the euro
  but they do not take part in the decision making
  process.

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The ECB.

• Two key decision making bodies
• The Governing Council - Governors of the NCBs
  (euroland) plus members of the Executive Board.
• The Executive Board - President Vice-President
  of the ECB plus four others selected by the heads
  of govt. Appointed for a non-renewable eight year
  term
• The Governing Council takes decisions on monetary
  policy (interest rate changes etc.) and the
  Executive Council issues instructions to the
  NCBs on how to implement policy decisions.

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The ECB

• The ECB is an independent central bank
• Maastricht Treaty
• National governments and EU institutions are
  prohibited from giving advise to the ECB
• The ECB cannot lend to national governments or EU
  institutions
• However, the Treaty charges the ECB with a
  primary responsibility to maintain price
  stability (not defined in the Treaty)

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The ECB

• Also, without prejudice to the price stability
  objective, the ECB is required to support the
  general economic policies of the EU -
  non-inflationary growth, economic convergence,
  employment etc.
• The ESCB are also responsible for day-to-day
  foreign exchange rate operations and exchange
  rate management.
• However Decisions on the euros participation in
  exchange rate systems are the responsibility of
  the European Council.

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The FED

• The Board of Governors in Washington D.C.
• Twelve regional federal reserve banks (NCBs)
• The Board of Governors seven members appointed
  by the President on a 14 year term. The Chair
  Vice Chair are appointed by the President on a 4
  year term.
• The Federal Open Markets Committee (FOMC) the
  seven Board members plus five regional reserve
  bank presidents (one of whom must be the
  President of the NY FED) on a rotating basis.

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The FED

• By tradition, the Chair of the Board chairs FOMC
  and the President of the NY FED is the vice-chair
• FOMC is the FED equivalent to the ECB Governing
  Council.
• FOMC, not the Board, decide monetary policy.

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The FED

• Note that only the Chair of the Board and the
  President of the NY FED have permanent votes on
  FOMC.
• The Federal Reserve Act does not stipulate a
  specific mandate for price stability - it charges
  the FED with responsibility for employment, low
  long-term interest rates price stability
• These objectives are not weighted

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ECB Policy

• Outlined in the Stability Orientated Monetary
  Policy Strategy (SOMPS)
• www.ecb.int click on publications, Monthly
  Bulletin, Jan. 1999
• ECBs prime responsibility is for price
  stability
• Defined as an inflation rate greater than 0 but
  no more than 2
• This target range is for the average euroland
  inflation rate, not for the inflation rate of an
  individual country.

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ECB Policy

• There are two pillars to SOMPS
• Monetary Targeting
• Inflation Targeting

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Monetary Targeting

• Quantity Theory MV Py
• M money supply
• P average price level
• y real GDP
• V velocity of circulation

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Monetary Targeting

• Let k 1/V
• M k(Py)
• Py nominal or monetary value of y
• k proportion of (Py) held in money balances -
  the demand for money
• Let x change in x
• m k p y

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Monetary Targeting

• m k p y
• ECB has a target for p, inflation (0 2)
• Given a forecast for k y what m is
  consistent with the inflation target?
• If forecast for y is 2 0.5 for k
• The m 4.5 is consistent with an inflation
  rate p 2

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Monetary Targeting

• This is known as the reference value for monetary
  growth.
• Deviations of actual monetary growth from the
  reference value MAY signal a change in interest
  rates

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Inflation Targeting

• ECB formulates its own inflation forecast pf
• If pf gt 2 then the ECB may tighten policy by
  raising interest rates etc.
• Note The ECB cannot change the current
  inflation rate. If the current rate is above 2
  this does not necessarily imply a rise in
  interest rates.
• The ECB will only react if its forecast is above
  2

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Policy Instruments

• To influence the inflation rate the ECB must use
  a range of policy instruments under its control
• Open Market Operations (OMOs) are the most
  important
• OMOs are the means by which the ECB provides
  liquidity or cash to the banking system.

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Policy Instruments

• Outright Transactions ECB buys sells
  securities in capital markets. If the ECB buys
  (sells) it increases (decreases) liquidity puts
  downward (upward) pressure on interest rates.
• Reverse Transactions or Main Refinancing
  Operations Two types - Fixed Variable Rate
  Tenders

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Policy Instruments

• Fixed Rate Each week the ECB announces the
  amount of liquidity it is prepared to make
  available to the market. Say 100m
• Banks can then bid for this liquidity in exchange
  for collateral assets.
• In effect banks are borrowing from the ECB the
  cost of this borrowing is the interest rate set
  by the ECBs Governing Council
• If the amount available is 100 total bids are
  200 then the bids are allocated pro rata - if
  bank A bids for 10m (5 of total bids) it
  receives 5m (5 of the available resources)

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Policy Instruments

• Variable Rate Because of overbidding the ECB has
  switched to variable rate tenders - banks can get
  additional liquidity at higher interest rates.
• Main point By changing the interest rate for
  refinancing operations (the rate at which the ECB
  lends to banks) the Governing Council can
  directly influence interest rates throughout the
  Eurosystem.

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