Monetary Policy and the European System of Central Banks

Posted on Jan 28, 2025 in Business Administration and Management (BAM)

Monetary Policy and the Central Bank

Effective January 1, 1999, Spain incorporated the Euro (€) as its national currency. Spain forms part of the Eurozone, and monetary policy became the responsibility of the European System of Central Banks (ESCB), which is composed of the central banks of the countries that have adopted the Euro as their currency, and the European Central Bank (ECB).

Functions of the European System of Central Banks

Promote and implement monetary policy.
Ensure the proper functioning of the payment systems.
Possess and manage foreign exchange reserves that are different from those of the ECB.
Conduct currency transactions necessary to maintain the Euro’s exchange rate against other currencies.

Objectives

To maintain price stability through the use of the money supply (M3). The interest rate determines the Eurozone.

Structure

Governing Council: Constituted by the governors of the Eurozone’s central banks. It sets the interest rate on the M3, makes decisions, and manages the reserves held by the ECB.
Executive Council: Composed of one president, one vice-president, and four counselors. It provides guidance to countries on making monetary policy frameworks and is responsible for routine administration.
General Council: Formed by the president, one vice-president, and the governors of the central banks. It gathers information, prepares reports, and compiles statistics.

Functions of the Central Bank

Implement monetary policy.
Monitor and promote the smooth operation of payment systems.
Monitor the solvency of credit institutions.
Issue legal tender notes after authorization by the ECB.
Develop and collect statistical information.
Advise the government and issue reports.
Serve as a financial agent of Treasury debt.

Monetary Policy Instruments

Reserve Requirement

Banks must hold a certain percentage of each bank deposit as reserves. For example:

If the reserve requirement increases:
1. Financial institutions must hold more reserves for each deposit.
2. The amount of money that can be allocated to loans decreases.
3. Liquidity in the system decreases.
4. Interest rates increase, which causes: Investment (I) and Consumption (C) to decrease, leading to a decrease in Aggregate Demand (DA).
Effects: Increases the level of output and employment, and increases inflation (ð).

Open Market Operations (OMO)

The buying and selling of financial assets by the ECB to modify the degree of liquidity in the economy. For example:

Bond purchase: Injects money into the system, decreasing interest rates, which causes: Investment (I) and Consumption (C) to increase, leading to an increase in Aggregate Demand (DA).
Effects: Increases production and employment, and increases inflation (ð).

Credits to the Banking Sector

The granting of more or fewer loans to the Eurozone banking sector by the monetary authority. For example:

Decreasing loans to the banking sector: Decreases liquidity in the system, increasing interest rates, which causes: Investment (I) and Consumption (C) to decrease, leading to a decrease in Aggregate Demand (DA).
Effects: Decreases production and employment, and decreases the price level.

Types of Monetary Policy

Expansionary Monetary Policy

Instruments:

Decrease banking reserves (increasing DA).
Open Market Operations (buying shares).
Decrease banking reserve credits.

These instruments increase the M3 (Money Supply = Cash + Deposits). If there is more money in the economy, the interest rate decreases, which causes: Investment (I) and Consumption (C) to increase, leading to an increase in Aggregate Demand (DA).

Effects: Increases output, increases employment, and increases the price level (ð).

Restrictive Monetary Policy