Economics Term Paper

Order Description

This is my main points for the paper:
1. History of EU: about EU and Euro.
2. Economic Policy and Exchange policy.
3. The beginning of ECB and ESCB.
4. Objectives of ESCB “price stability”.
5. Tasks of Euro system.
6. Decision making systems: members, responsibilities, independence.
7. Monterey Policy: strategies and operation.
8. Foreign Exchange: rate and reserve.
9. The new policies 2014-2015.

The main source will be the ECB website
https://www.ecb.europa.eu/home/html/index.en.html

Also, there is a paper which included all main points and we can use it as second source
Finally, for the last point which is the new policies or the changes in ECB there are two good papers for that. Also, I need cover page and page of content.

 

Answer

Title: European Central Bank

Contents

Introduction. 2

History of EU: About EU and Euro. 2

Economic Policy and Exchange policy. 5

Economic Policy. 5

Exchange Policy. 7

The Beginning of ECB and ESCB. 8

Objectives of ESCB: Maintaining Price Stability. 11

Tasks of Eurosystem.. 13

Decision Making Systems: Members, Responsibilities, and Independence. 15

Members. 15

Responsibilities. 16

Independence. 17

Monetary Policy: Strategies and Operations. 19

Foreign Exchange: Rate and Reserve. 22

The New Policies for 2014-2015. 22

Conclusion. 23

References. 25

 

Introduction

Europe has gone through a long process of developing an integrated monetary system and a single currency. When the European Central Bank (ECB) was finally established, it marked a major milestone for member states of the euro area. The history of the ECB and the single currency (the euro) is intricately intertwined with that of the common European market that started in 1958 as the European Economic Community (Scheller, 2006). Today, the ECB, the Eurosystem, and the European Union (EU) constitute a powerful socio-economic and political regime that goes beyond economic and political cooperation by embracing the adoption of a single currency.

The aim of this paper is to provide insights into the history of the EU, the euro, the ECB and the Eurosystem. It investigates the rationale for a common political-economic regime in Europe and the various stages involved in the actualization of this vision. Towards this end, the paper examines aspects of European economic and exchange policy, the origin of the ECB and the ESCB, the objective of the ESCB in terms of maintaining price stability, and the task of the euro system. The paper outlines the institution’s decision-making systems in terms of members, responsibilities, and independence in order to create a clear picture of how the ECB operates. In this context, policy specific actions relating to strategies, operations, foreign exchange rates, and foreign exchange reserves are analyzed. Lastly, this paper reviews some of the new policies that the ECB has introduced for 2014 and 2015.

History of EU: About EU and Euro
The origin of the European Union (EU) may be traced to the political events that unfolded in Europe during the 1950s. One of them is the formation of the European Coal and Steel Community (ECSC), whose member states included the Netherlands, Luxembourg, Italy, Germany, France, and Belgium. In 1958, the same countries formed two more unions: the European Atomic Energy Community (Euratom) and the European Economic Community (EEC). Some of the countries that joined the three communities afterwards include Greece, Denmark, Portugal, and Spain.

To enhance unity and cooperation among EU member states, two major laws were enacted: the Single European Act in 1986 and Maastricht Treaty (Treaty on European Union) in 1992. The latter established the European Union by outlining a governance structure that comprised of three pillars: the three European Communities, the common system of justice and judicial cooperation, and the common security and foreign policy. In 1997, amendments to both the Treaty on European Union and treaty that established the European Community were amended in the Treaty of Amsterdam. Since then, several measures have been put in place to create the foundation for an enlarged EU, such as signing of the Treaty of Nice. This paved the way for many European countries to join the union, including Austria, Sweden, Finland, Cyprus, Hungary, Estonia, Slovakia, Poland, Slovenia, Lithuania, Cyprus, and he Czech Republic. By 2003, the EU had a membership of 25 states. The treaty that governs EU’s operations today was agreed on in the 2004 treaty in which the objective was to establish a constitution for Europe.

Other than the formation of a single market and a political union, which was the primary objective of the EU, European countries have also made progress in efforts to adopt a single European currency, the euro (Scheller, 2006). The earliest steps towards European monetary integration may be said to have been taken during the 1960s. The first proposal for the formation of an economic and monetary union was made by the European Commission in 1962. Two years later, a step towards the institutionalization of cooperation among central banks of the EEC was made with the formation of a committee of Governors of these central banks.

Over the years, EU member states have used different strategies in the pursuit of the single-currency vision, including self-imposed deadline. One such deadline was imposed in a 1971 report, which outlined a plan to roll out European Economic and Monetary Union (EMU) by 1980. The second deadline was set in 1989, in which case the European Council adopted the recommendations of a report proposing plans to ensure that EMU was realized before the year 2000. However, the task of creating a single currency proved to be a gradual process and not an event. In 1972, EEC member states introduced a system through which the margins of fluctuation between different member states’ currencies would be progressively narrowed. To foresee smooth operations of the system, the European Monetary Cooperation (EMCF) was established, followed years later by the European Monetary System (EMS).

In the 1989 “Delors Report”, which proposed that EMU should be realized before the year 2000, three stages that the European Council would adopt to actualize the dream were outlined. Stage One required EU member states to complete the realization of an internal market, remove barriers to financial integration, reduce disparities between the economic policies of different states, and intensify the process of monetary cooperation. Stage Two was defined as a transition period, whereby member states would set up EMU’s organizational structure as well as its basic organs in preparation for the final stage. Stage Three would involve locking all exchange rates and assigning full economic and monetary responsibilities to all the bodies and institutions of the monetary union.

Stage one began in 1990; in December the same year, the European Commission held an Intergovernmental Conference in preparation for the other two stages. The signing of the Maastricht Treaty in 1992 set the platform for the establishment of Frankfurt am Main as the headquarters for both the European Central Bank (ECB) and the European Monetary Institute (EMI). The signing of the Treaty on European Union in 1993 also marked a significant step towards the realization of a single European currency. A year later, EMI was established together with Stage Two of the EMU-formation process.

The name “euro” was finally adopted by the Madrid European Council as the name of the single European currency. The Council also weighed options for cash changeover by various EU member states, including aspects of adoption across Europe. By this time, the stage had been set for the printing of specimen bank notes, establishment of a legal framework governing the use of the currency, and the assessment of eligibility criteria for EU member states. The first member states to fulfill the criteria for the adoption of the currency in 1998 included Germany, France, Italy, Ireland, Spain, the Netherlands, Luxembourg, Finland, Portugal, Austria, and Belgium.

Stage Three of the process of realizing the vision of EMU started in 1999. By this time, both the European System of Central Banks (ESCB) and the ECB (European Central Bank) had been established. The ECB had even announced the operational framework and long-term strategy for the single monetary policy. The start of Stage Three was marked by the adoption of euro as the single currency of the so-called “euro area”. Former national currencies of the member states that adopted the new currency were replaced through irrevocable fixing of conversion rates. In effect, the member states that joined the euro area were required to adopt a single monetary policy.

Economic Policy and Exchange policy

Economic Policy

In the EU, the ECB is recognized as the main source of strategic imperatives for both the Euro-system and the ESCB. It plays the role of ensuring that economic operations in the euro area are undertaken in an effective manner using the single monetary policy. It provides an ideal focal point for centralization of decision-making. This is particularly important in situations where certain monetary policy decisions have to be made on a regular basis. At the ECB, efforts are ongoing to facilitate the institutionalization of appropriate frameworks for safeguarding both economic excellence and political accountability. In this regard, focus is on two core areas: economic policy and exchange policy.

In economic policy, the primary responsibility has remained with the EU member states. This requirement is stipulated in the EC Treaty, which requires member states to coordinate all economic policies closely in the pursuit of common objectives. The Treaty stresses the need for member states to treat EU economic policies as a matter of concern to everyone. Towards this end, the Treaty outlines the Broad Economic Policy Guidelines (BEPGs), which constitute a foundational policy instrument on the basis of which national economic policies are coordinated. Through BEPGs, information on economic policy can be derived for use in both general situations involving the Community as well as specific cases affecting individual member states.

The various policy areas addressed by the BEPGs include structural reforms, training and education, labour market regulation, and taxation. In essence, they provide a standard against which member states can measure the performance of both national- and EU-level institutions (Scheller, 2006). This framework takes the form of a mere recommendation rather than a legally binding instrument. Instead, EU member states count on the power of persuasion to mobilize government support for different economic-policy stances. Nevertheless, the fact that the BEPGs have been endorsed by the European Council gives them immense political weight. This approach has greatly contributed to the harmonization of the economic policy of the EU and the euro area.

The economic policy of the euro zone is also being shaped by the development of specific “processes” that constitute an integral part of efforts to enhance the way the ECB and ESCB operate. These processes are popularly named after the areas where they were initiated. For instance, in the Luxembourg process, EU member states seek to coordinate procedures for employment policies at the national level with a view to develop a uniform labour policy across the euro zone. These efforts have already led to the development of Employment Guidelines on an annual basis. These guidelines provide recommendations on areas of action that require special attention. Some of the issues that have arisen during deliberations based on these guidelines include labour market reform, training, education, and coordination of national action plans into a coherent economic plan for the Union.

EU member states have also embarked on the Cardiff process, Cologne process, as well as the Lisbon Strategy. The Cardiff process focuses on monitoring and peer-reviewing of the structural reforms undertaken by the Union. A core component of this process is the multilateral surveillance of the economic reform process. To succeed in this review, the Economic Policy Committee examines annual reports submitted by both the European Commission and EU member states. On the other hand, the Cologne process constitutes an ideal platform on which the ECB, national governments, the European Commission, and various social partners can engage in macroeconomic dialogue. In this dialogue, these participants exchange views on the economic situation in Europe as well as prospect of the Union.

Exchange Policy

The exchange policy of the euro area is stipulated in the EC Treaty (Article 12). This article requires member states to observe normal fluctuation margins that fall within the limits outlined in the EMS’s exchange-rate mechanism (ERM). In this mechanism, member states are prohibited from devaluing their currency against that of other member states for two years. During these two years, member states are required to respect normal fluctuation margins stipulated by the EMS without causing any severe tensions. In effect, this bars member states from taking the initiative to devalue their bilateral central rates.

The EU places emphasis on ensuring that exchange rates do not deviate too much from the respective ERM central rates. This policy direction is evident in way the ECB and the EMI respond to the convergence reports submitted to them since 1998. At the conception of the EC Treaty, the fluctuation margins were set at ±2.25 percent in relation to bilateral central rates. In 1993, the margin was extended to ±15 percent. At the same time, an element of vagueness emerged in regards to the interpretation of the term “normal fluctuation margins”. This necessitated efforts to take into account developments in each exchange rate within the EMS in order to come up with a straightforward interpretation.

The Beginning of ECB and ESCB

The first step towards the formation of the ECB and the ESCB was made when the idea of a common European currency was first fronted by the European Commission in 1962. At this time, European countries were part of a fairly stable international monetary system. This system operated through fixed but adjustable exchange rates. This system, commonly known as the Bretton Woods system, continued to be a relatively stable platform until the late-1960s. At first the need to expound on the need to introduce a single European currency did not arise. The Committee of Governors of EEC member states’ central banks opined that since the Bretton Woods system ensured global exchange rate stability, it was better for the member states to divert their attention to the establishment of exchange rate stability at the intra-EEC level.

The formation of the Committee of Governors marked a crucial initial step in the long journey towards the formation of the ECB and the ESCB. The mandate of this Committee started to increase gradually as the Bretton Woods system started showing signs of strain because of the US policy on balance of payments. The Committee became the most important frontier through which efforts towards monetary cooperation among central banks in the EEC could be promoted. It is against this backdrop that the second proposal, the Barre Plan, was developed with a view to establish a distinct monetary policy within the Community. This plan set the stage for a meeting of Heads of State and Government in Hague, where the Council of Ministers was called upon to deliberate on a plan aimed at realizing the stages of a monetary union.

In 1973, the European Monetary Cooperation Fund (EMCF) was established. Member states envisaged that the Fund would narrow fluctuation margins of their currencies. The EMCF may be viewed as the forerunner of the ECB and the ESCB. This is because it formed the core of future efforts to manage the way central banks of member states were managed. Unfortunately, the process of forming a single currency and central bank lost momentum considerably. This is primarily because member states adopted divergent policy responses to the serious economic shocks that rocked the world during that era.

To avoid such differences in policy responses while at the same time re-launching the monetary integration process, the European Monetary System (EMS) was established (Scheller, 2006). Participating central banks greatly contributed to this process by contributing to deliberations on operating procedures. EMS promoted flexible but easily adjustable central rates. It also led to the establishment of the European Currency Unit (ECU), where member states put fixed quantities of their currencies. The objective was to create a reserve asset as well as a settlement platform for European central banks.

Other benefits realized during the tenure of the EMS system included internal monetary stability, exchange rate stability, relaxation of capital controls, ease of pursuing disinflation policies, and moderation of cost increases in participating countries. The net effect was an overall improvement in economic performance. This performance proved to be sustainable because intra-European trade was protected from exchange rate volatility. However, tension remained on the front of fiscal policy primarily because of large budget deficits in some countries. These deficits greatly contributed to the exchange rate crises of the early 1990s.

Within the signing of the Single European Act (SEA), the process of further monetary integration that led to the establishment of the ECB and the ESCB was still on course. Just like the Treaty on European Union, SEA contributed to the creation of an appropriate policy coordination environment, which European countries needed to mobilize before forming a single currency, the ECB and the ESCB. When the three stages of monetary integration were finally conceived, Europe came closer to realizing its dream of a monetary union.

As the EEC changed its name to EC (European Community) during Stage One through the enactment of the EC Treaty, the Statute of the ESCB and the EMI Statute were also attached as Protocols. The official process of changeover to the euro started with the abolishment of all restrictions on capital movement among member states. This move was accompanied by the introduction of new responsibilities for the Committee of Governors. The core objective was to achieve price stability in the movement of capital within participating states.

With the formation of the Council of the EMI, a framework for monetary policy coordination and the strengthening of central bank cooperation had been established. The Council of the EMI was also given the responsibility of ensuring that member states had met all requirements for the establishment of the ESCB. With the ECB and ESCB in place, it would be easy for a single currency to be introduced in Stage Three. The ESCB was given the responsibility of circulating the new euro banknotes in 2002. In 1998, the ECB was established in 1998. It took over the EMI infrastructure, including its preparatory work, and staff body, which was taken through extensive training in preparation for its work at the ECB. These efforts were instrumental in enabling the ECB to operationalize the Eurosystem in less than one year. This speeding-up of the transition from the EMI to the ECB also set the stage for the cash changeover, which was planned to start on 1 January 2012. By this time, Stage Three was well underway, ECB and ESCB had taken over full responsibility for the single monetary policy, and a legal framework had been established to oversee this process.

Objectives of ESCB: Maintaining Price Stability

The main objective of the ESCB, as outlined in the EC Treaty, is the maintenance of price stability. In this treaty, the chapter on monetary policy presents information on the scope and limits of the various organizations and institutions that constitute the central banking system of the EMU. This information dwells primarily on the various ways through which the ESCB can maintain price stability.

There are several reasons why it is prudent for the organizational and institutional platforms established under ESCB to address the issue of price stability. To begin with, practical experience suggests that citizens’ living standards and economic prospects can be raised by ensuring that price stability is maintained in a sustainable manner (Scheller, 2006). The second reason for pursuing the objective of price stability is that from a theoretical perspective, whereby the overriding argument is that the ultimate impact of monetary policy can only go to the extent of influencing the price level with the economy (Scheller, 2006).

The theoretical foundation of the ESCB’s operation rests on the monetary policy’s capacity to ensure that price stability is achieved over the medium term. The assumption in this case is that the banking system is dependent on the central bank as the sole authority responsible for issuing money. Based on these assumptions, the objective of the ESCB can be met by meeting demand for currency that has been put into circulation, meetings the requirements of minimum reserves that must be deposited with the ECB, and clearing interbank balances. This means that on a medium-term basis, price stability is the only feasible objective that the ESCB can pursue. On a long-term basis, it is impossible to widen the scope of the monetary policy to enable it to influence real variables in any significant way.

Since the ESCB has already been given monopoly over the establishment of base money, it can successfully influence market interest rates as well as money market conditions. It also has the responsibility of setting in motion the process of influencing economic variables, commonly known as monetary-policy transmission mechanism. To perform this role, the ESCB needs to bring on board economic agents at different stages. This role is important considering that a lag normally exists between monetary policy action and its impact on price developments.

Moreover, it is generally accepted in economics that all other factors remaining constant, the quantity of base money injected into an economy influences prices while exerting little or no long-term impact on real variables such as unemployment or real output. In relation to this assertion, inflation is viewed as a distinctively monetary phenomenon. Based on these theoretical propositions, it is not difficult to espouse a situation where the ESCB will successfully achieve the goal of maintaining price stability through adjustments in the existing money stock.

In price stability, focus is on the level of prices in general within an economy, such that ways of preventing periods of prolonged deflation and inflation are devised. Once price stability is maintained, economic development can be achieved in various ways. For instance, it can become easier for relative changes in prices to be recognized. It can also create confidence among investors regarding future stability, thereby reducing risks associated with long-term use of nominal assets. Moreover, price stability discourages firms from diverting resources towards measures aimed at hedging against inflation. Instead, the firms put these resources into productive use.

For a long time, European economies encountered the problem of welfare and tax systems that offered incentives that trended to distort economic behaviour. These distortions tended to be exacerbated by deflation and inflation. Since the introduction of the price-stability mechanisms of the ESCB, the problem that used to occur in the form of the emergence of real economic costs following the implementation of social security and tax systems has been resolved. At the same time, the ESCB has performed exemplarily well in preventing arbitrary redistribution of income and wealth as it seeks to maintain price stability. In an environment where prices remain stable, it becomes easy for various organizations and institutions to promote the values of economic stability and social cohesion.

Tasks of Eurosystem

            The Eurosystem, or the ESCB, is predominantly responsible for performing the central bank function. This is a critical task that has been assigned to it by the EC treaty, specifically article 105(2). This article assigns several tasks to the Eurosystem. They include defining and implementing the euro area’s monetary policy, holding and managing official foreign reserves held by the member states of the euro area, conducting foreign exchange operations, and issuing euro banknotes. The Eurosystem is also responsible for collecting statistical information required for smooth operations within the euro area.

The overall objective of the Eurosystem is the formulation and implementation of the euro area’s monetary policy. Ideally, member states envision a situation where this task is consistently performed to ensure that the ECB has full control over all base-money operations. Article 106 of the EC Treaty recognizes the NCBs (National Central Banks) and the ECB as the only institutions that are mandated to issue banknotes within the euro area. The right by member states of the euro area to mint coins is restricted to low-denomination coins subject to the approval of the ECB. Since the banking system depends on base money, the Eurosystem thus exerts tremendous influence on interest rates and conditions in the money market.

Foreign exchange operations have also been assigned to the Eurosystem. In this regard, the objective is to exploit the central banks’ operational capabilities while at the same time ensuring that foreign exchange operations are in line with requirements of monetary policy as outlined in the EC Treaty. These capabilities exist because of the responsibility that the ECB shares with the EC Council in decision-making. By examining aspects of both domestic liquidity conditions and exchange rates, the Eurosystem stands a good chance of succeeding in the management of foreign exchange operations.

The Eurosystem is also responsible for the management of official foreign reserves within the euro area. This task complements the function of managing foreign exchange operations. In discharging this mandate, the Eurosystem seeks to complement the power conferred upon the ECB under Article 31 of the EC Treaty. This article spells out the responsibility of the ECB to control how member states maintain residual working balances in the form of foreign currencies as well as NCBs use foreign exchange holdings.

In line with the need to promote efficient systems for conducting the monetary policy, the Eurosystem promotes smooth operations of various payment systems. To be able to perform these tasks, the Statute governing the ESCB assign a wide range of operational and functional competencies to all the euro area NCBs as well as he ECB. Furthermore, the ECB has been accorded regulatory powers, such that it can impose enforceable sanctions whenever there is non-compliance with ECB Regulations and Decisions. It has also been assigned the role of ensuring that the NCBs comply with existing regulations.

In addition to these tasks, the Eurosystem is also responsible for ensuring that policies are conducted by competent authorities, particularly in regards to the way credit institutions are supervised. Whenever some instability starts to appear within the financial system, it is the responsibility of the Eurosystem to contribute to various corrective mechanisms introduced by NCBs and the ECB. However, the statute governing the ESCB restricts this institution’s participation to a contributory scope. Moreover, the role that the Eurosystem should play is not clearly specified. Despite these shortcomings, it is obvious that the institution has a legitimate interest in the arrangements put in place in the euro area to facilitate prudential supervision as well as long-term financial stability.

Decision Making Systems: Members, Responsibilities, and Independence

Members

The Eurosystem is governed by the decision-making bodies of the ECB. An underlying principle that governs various bodies within the Eurosystem is the centralization of decision-making and decentralization of operations. In the ECB, for instance, decision-making entails not just the formulation of policies but also their implementation. To facilitate smooth implementation of policies, a principle of decentralization has been developed. This system provides insights into the division of labour within the system.

Decision-making in the ESCB and the Eurosystem is governed by two main bodies: the Executive Board and the Governing Council. There is also a third decision-making organ, the General Council, which will cease to exist when all EU member states adopt the euro. These three bodies make their decisions based on the requirements of the Statute of the ESCB, the EC Treaty, and different Rules of Procedure. The outcome of this framework is the emergence of a two-layer approach, whereby both the Executive Board and the Governing Council make crucial decisions in their respective areas of specialization to enable the ECB to respond appropriately to developments in the monetary system.

The Governing Council is the primary decision-making organ of the European Central Bank. It is responsible for making the most strategically important decisions in the Eurosystem. All the member states that have adopted the euro are represented in the Governing Council through the governors of the respective NCBs. The Executive Board participates in the Governing Council’s decision-making in a manner that enables its members to have rights and responsibilities similar to those of NCB governors. This objective of this approach is to promote the conception of the ECB as a supranational body. By getting involved in decision-making, the Executive Board brings into focus the expertise required in the process of implementing ECB’s policies.

Responsibilities

The Governing Council is tasked with the responsibility of making all decisions of the Eurosystem with the exception of those assigned to the Executive Board. The Council formulates the monetary policy that all states in the euro area should adopt. For instance, it outlines the overall monetary policy strategy of the ECB by addressing issues such as interest rates and processes for the execution of specific monetary policy operations by NCBs within the Eurosystem. In essence, the Governing Council issues guidelines on how NCBs should operate. It also adopts regulations to be enacted by the ECB in addition to authorizing the issuance of euro banknotes and euro coins. All rules of NCB operations in terms of standardized accounting and reporting are also developed by the Council. The Council also initiates legislation in line with the fulfillment of its advisory function to the ECB and the Eurosystem. Additionally, the Council allocates financial resources to the European Central Bank, appropriates its financial results, and adopts rules of monetary income allocation among NCBs in the euro area.

Independence

The principle of independence has already been enshrined in both the Statute of the ESCB and the EC Treaty. The objective was to ensure that the integrated monetary order that was established in Europe was free from political interference. The fact that this principle has been enshrined in these treaties as opposed to secondary legislation gives it “constitutional” status. The principle was formulated in this manner because it was viewed as a requirement for the maintenance of price stability.

It is imperative for the ECB to be protected from different spheres of influence that may interfere with its mandate of achieving its primary objective. By maintaining independence, the central bank is in a position to not only maintain price stability but also achieve the status of a credible institution. In many cases, governments tend to pursue objectives that are not necessarily in the interest of the price-stability objective. To deter such governments from using the ECB as a tool for achieving their political objective, independence becomes a useful guiding principle.

The different aspects of independence that continue to be accorded priority include legal, institutional, personal, functional, and financial independence. These aspects are being extended to the NCBs as well as their respective decision-making bodies. This is because the NCBs also have a crucial role to play in contributing to price stability within the Eurosystem. Institutional independence has been enshrined by making it illegal for all decision-making bodies within the Eurosystem, ECB, and the ESCB to take instruction from any bodies within the EU, any government, or any other body. The wording of Article 108 of the Statute of the ESCB makes it illegal for decision-making bodies within the ECB and the NCBs to take any instructions from any organization, whether private or public, national or international. Similarly, a platform for legal independence has already been created, whereby the ESCB enjoys its own legal personality. This means that it can bring legal actions before the ECJ (European Court of Justice) as a way of protecting its independence in case it is violated by an EU member state or institution.

To promote personal independence, the Statute of the ESCB stipulates fixed terms of office for members of the decision-making bodies of the ECB. For instance, NCB governors’ term of office is five years and can be renewed while that of Executive Board members is eight years without the option of renewal. The Statute also prohibits dismissal on the basis of poor policy performance in the past. Rather, the law only provides for the removal from office if a member is unable to fulfill all the conditions required for the execution of his duties or if he is found to have engaged in serious misconduct.

The Statute also seeks to protect functional and financial independence of the Eurosystem. For instance, this is the only institution that is mandated to issue legal tender banknotes in the euro zone. It is also responsible for controlling foreign reserve holdings within the Eurosystem. On the other hand, the EC treaty shields the Eurosystem against public sector pressure by preventing it from borrowing from this regulatory institution. Moreover, the Eurosystem has been accorded express authority to use different instruments to implement its policies. These instruments take the form of regulatory powers as well as the power to impose various enforceable sanctions whenever different institutions, member states, and other parties fail to comply with the regulations and decisions of the ECB. A similar strategy has been adopted to safeguard the Eurosystem’s financial independence. For instance, ECB prepares its own budget that is independent from the EU’s budget. Moreover, the ECB enjoys autonomy in setting up employment conditions for its employees as well as setting up internal structures.

Monetary Policy: Strategies and Operations

            The ECB and ESCB are a core component of the framework that European countries created with a view to establish a single monetary policy. For these efforts to succeed, it is imperative for various strategies to be put in place. An ideal strategy is one that addresses different aspects of the monetary policy. To achieve this objective, the ECB has adopted a quantitative approach in its definition of price stability. The aim is to ensure that all the relevant information is analyzed to form a basis for making forward-looking policy decisions.

A potential challenge for the ECB is that the EC Treaty fails to define price stability. It is for this reason that the Governing Council chose to adopt a quantitative approach in its definition of this concept. The need to adopt this approach was also influenced by the need to promote transparency in monetary policymaking while at the same time providing a yardstick against which the ECB could be held accountable by the public. Once people notice price deviations, they expect the ECB to account for it and to be given an explanation regarding the measures being undertaken to re-establish price stability within the shorted time possible. The definition also guides member states’ expectations regarding future price development, thereby increasing the credibility of the ECB’s monetary policy.

The ECB puts a premium on the ability to influence short-term interest rates in order to be able to take full control over medium-term price stability. It uses the transmission process of the monetary policy in efforts to ensure that a systematic approach is adopted in all monetary policy decisions in a consistent manner. Because of such consistency, inflation expectations are stabilized. This stabilization goes a long way in promoting the credibility of the ECB.

Unfortunately, the transmission process tends to encounter lags, such that any monetary policy changes that the ECB makes today may take months or sometimes even years to have any significant affect price levels. This means that as a matter of strategy, the ECB and NCBs must ascertain the policy position that they should take today in order to maintain price stability in years to come. For this reason, the monetary policy should be future-oriented. Similarly, the transmission lags render the ECB ineffective in responding to unanticipated economic shocks that affect price stability. For example, it is difficult for the policy to address sudden price changes caused by a slump in commodity prices in the international market. For this reason, member states in the euro area must accept the reality that instability in inflation rates on the short run is inevitable.

The ECB also settles for medium-term policy-making because of the need to reduce excessive activism as well as attempts by entities with vested interests to cause shocks in the real economy. The decision to promote a broad-based approach to monetary policy is also beneficial because all central banks, including the ECB operate in the context of considerable level of uncertainty. To be successful, most central banks opt to put into consideration a diverse pool of relevant information rather than relying on a single economic model. Like these central banks, the ECB has adopted a broad-based strategy, with the objective being to maintain a strategic position in its role of maintain price stability in the medium term.

The ECB also uses a two-pillar approach, which was developed in 2003, to outline its monetary strategy. The first pillar assesses price developments based on short- and medium-term determinants. In other words, it entails economic analysis. The second pillar provides a platform through which indications derived from the economic analysis are cross-checked using medium- and long-term perspectives. The objective is to ensure that all perspectives are examined to form an objective appraisal of risks posed to price stability. In other words, this second pillar entails monetary analysis. This approach was adopted to enable it to organize, evaluate, and cross-check information that forms the basis of assessing risks posed to price stability. The use of economic and monetary analysis reduces the risk posed by overreliance on a single model to interpret economic conditions.

In terms of monetary policy operations, the ECB seeks to steer money market rates on a short-term basis to leverage its monetary policy stance as well as to manage liquidity in the money market. It also leverages its policy stance by changing the conditions governing the Eurosystem’s decision to enter into transactions within the money market. The ECB seeks to influence the Eurosystem’s operations in an effort to establish an environment where the money market functions in an orderly manner. This approach is founded on the premise that banks should always be given the capacity to operate in a well-organized manner by having their liquidity needs reliably met at all times.

The Statue of the ESCB and the EC Treaty provide an operational framework for the Eurosystem. These laws require the Eurosystem to operate based on the principles of a free market economy. Other principles guiding operations within the Eurosystem include operational efficiency, decentralization of monetary policy operations, simplicity, continuity, and transparency. The rationale for simplicity and transparency is to promote clarity of intent as far as all monetary policy operations are concerned. On the other hand, continuity should also be promoted because it can be a source of experience for central banks in terms of the changes that need to be injected into existing procedures and instruments.

Foreign Exchange: Rate and Reserve

The Eurosystem also intervenes in the area of foreign exchange operations. The ECB holds sufficient foreign reserves, which it uses to effect intervention operations. In some cases, these operations are conducted using currencies of countries that are not necessarily member states of the European Union. They are also conducted through the exchange rate mechanism II (ERM II), which is an intra-Community foreign exchange platform.

Both the Statute of the ESCB and the EC Treaty provide the institutional framework through which the exchange rate policy of the euro area is implemented. For example, Article 111(1) of the EC Treaty mandates the EU Council to enter into formal agreements governing an exchange rate system. Article 111(2) gives the Council the authority to come up with general orientations for an exchange rate policy in case an exchange rate system has not been put in place. The only caveat for these provisions is that all measures adopted must respect the core mandate of maintaining price stability. To secure this goal, a requirement has been imposed, whereby only the ECB or the EC in consultation with the ECB can recommend the commencement of all institutional measures.

The New Policies for 2014-2015

The ECB has continued to introduce new policies to streamline its operations. The policies relate to the setting of interest rates, new distribution of duties and responsibilities for Executive Board members, as well as measures aimed at reducing lag in the transmission mechanism of its monetary policy. For example, on June 5, 2014, ECB announced new monetary measures it envisaged would enhance its monetary policy (European Central Bank, 2014). The new policy is also expected to support lending in the real economy. The Governing Council hopes to achieve this objective by conducting Targeted Longer-Term Refinancing Operations (TLTROs) and intensifying preparatory work regarding asset-backed securities. The objective of introducing TLTROs is to improve lending to non-financial private sector within the euro area.

On June 12, 2014, the ECB also put in place a negative interest rate (European Central Bank, 2014). This decision was taken because of the need to maintain inflation rate close to 2 percent but below it over the medium term. The Governing Council arrived at this decision after predicting that inflation in the euro area would remain below 2 percent in the long term. In that case, the Council decided that it only made sense to lower the interest rates. This policy measure is part of a wider monetary-policy actions aimed at maintaining price stability with a view to create an ideal environment for sustainable economic growth within the euro area.

Lastly, the ECB announced on July 23, 2014 that Lithuania would join euro area on January 1, 2014 (Deutsche Bundesbank Eurosystem, 2014). It is also at this time that the country will become a member of the Single Supervisory Mechanism (SSM). This means that beginning 2015, Lithuanian banks will be operating under the direct supervision of the ECB. This takeover of the supervisory role will be preceded by a comprehensive assessment of the resilience of major banking institutions in the country by the ECB (Bancode Espana Eurosistema, 2014).

Conclusion

The process of establishing a single monetary policy and currency started during the late 1950s with the idea of a single market and a political union. Since then, the member states of the European Economic Community have accumulated a wealth of experience that has greatly contributed to the actualization of the ultimate vision: the adoption of a single currency. As more European countries joined the economic and political union, member states started developing immense interest in establishing a political union and finally a single currency. With the establishment of the ECB, the ESCB, and the Eurosystem, both objectives may be said to have been achieved.

This paper has focused primarily on the history of the ECB. Its findings indicate that the primary objective of establishing the ECB was to maintain price stability in the medium term. This objective is being pursued because price stability is considered a major prerequisite for sustainable economic growth. To achieve price stability the ECB has put in place decision-making systems whose format is anchored in two laws: the EC Treaty and the Statute of the ESCB. As the core component of the Eurosystem, the ECB is expected to operate in liaison with the ESCB and the NCBS in setting up and implementing monetary policies that promote the objective of price stability.

 

References

Bancode Espana Eurosistema. (2014). The ECB Governing Council adopts a rotating system for voting after Lithuania joins the euro area. Madrid: Bancode Espana Eurosistema.

Deutsche Bundesbank Eurosystem.(2014). How voting rights rotate on the ECB Governing Council. Frankfurt am Main: Deutsche Bundesbank Eurosystem.

European Central Bank. (2014). Press releases published in 2014. Retrieved from https://www.ecb.europa.eu/press/pr/date/2014/html/index.en.html  on September 22, 2014.

Scheller, H. (2006). The European Central Bank: history, role and functions (Second revised edition). Frankfurt am Main: European Central Bank.

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