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Macroeconomics 6. The Monetary Policy of the ECB

Macroeconomics 6. The Monetary Policy of the ECB. Macroeconomics. 6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB 6.3. Money Creation by Commercial Banks 6.4. Questions for Review Literature:

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Macroeconomics 6. The Monetary Policy of the ECB

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  1. Macroeconomics6. The Monetary Policy of the ECB Prof. Dr. Rainer Maure

  2. Macroeconomics 6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB 6.3. Money Creation by Commercial Banks 6.4. Questions for Review Literature: ◆ Chapter 18, Mankiw, Gregory; Macroeconomics, Worth Publishers. ◆ Kapitel 25, Blanchard / Illing, Makroökonomie, Pearson Studium. ◆Kapitel 17, 18, Baßler, Heinrich; et al. Grundlagen u. Probleme der Volkswirtschaft, Schäfer und Poeschel. Prof. Dr. Rainer Maure

  3. Macroeconomics 6. The Monetary Policy of the ECB      6.1. The Policy Target of the ECB Prof. Dr. Rainer Maure

  4. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • The policy target of the ECB is legally defined by the EU treaty (Art. 4.2; Art. 105) and in the ECB-Statute (Art. 2): • Primary target is “to guarantee price stability“. • In the so called “Protocol on Convergence Criteria" article 1 statues that • “price stability" is defined by the “Consumer Price Index". • In a press release of 13.10.1998 the ECB-Council declared: • “Price stability is defined as a yearly increase of the “Harmonized Consumer Price Index” (HCPI) of the Euro Currency Area of less than 2%. Price stability shall hold over the medium term." Prof. Dr. Rainer Maure

  5. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • In the pursuit of this target the ECB is independent from the influence of governments or other political institutions. • This is guaranteed by article 107 of the ECB-Statute: • Given this statute, the ECB is one of the most independent central banks of the world. • Article 107 • “neither the ECB, nor a national central bank, nor any member of their decisionmaking bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body.” • (Statute of the ESCB and of the ECB) Prof. Dr. Rainer Maure

  6. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Empirical studies show, that political independence of central banks leads to lower average inflation rates: Prof. Dr. Rainer Maure

  7. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Similarly as the ECB, other modern central banks have also a publicly declared inflation target: • Bank of England: 2,5% RPIX1) ≈ 1,75% HVPI1) • Riksbank of Sweden: 2 ± 1% VPI1) • Norwegian Central Bank: 2½ ± 1% VPI • Bank of Canada: 1% bis 3% VPI • Bank of Australia: 1 bis 3% VPI • Reserve Bank of New Zealand: 1% bis 3% VPI • Swiss Nationalbank: Adoption of the ECB inflation target • US-Federal Reserve System: : 1,5% - 2% PCE 1) RPIX = Retail Price Index; HVPI = Harmonisierter Verbraucherpreisindex; VPI = Verbraucherpreisindex; PCE= Personal consumption expenditures price index Prof. Dr. Rainer Maure

  8. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • But why do basically all central banks have an inflation target above zero and not simply equal to zero? • In the monetary policy debate, a couple of reasons for an inflation target larger than zero are discussed. The most important are: • Danger of a deflation spiral in the presence of a zero inflation target. • Potentially useful psychological effects in the presence of sticky nominal wages. • The possibility to generate negative real interest rates. • All these arguments are heavily disputed – there exists no unanimity on these issues! Prof. Dr. Rainer Maure

  9. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Danger of a deflation spiral: • How would you react, if you wanted to buy new furniture for your apartment and you knew that the prices for furniture would decrease by 5% over the next year? • What would happen with the total demand for goods, if on average everybody would act this way? • How would this affect the business cycle? • In chapter 3 we simply assumed that households will not react in case of a deflation. However, this in not necessarily so: • In the presence of deflation, it is possible that households further postpone their consumption into the future, because they expect lower prices for goods in the future (naïve expectations). • This however means that the consumption ratio will furtherdecrease and the recession will therefore deepen. • Some historians are convinced that it was a mechanism like this one that has caused the world economic crises of 1929-33. Prof. Dr. Rainer Maure

  10. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB Inflation Rate UPSWING UPSWING DOWN-SWING DOWN-SWING Inflation Target (=Long Run Average) = 2% Actual Realization of Inflation 3% B O O M B O O M R E C E S S I O N R E C E S S I O N 2% 1% Time 0% In reality no central bank succeeds in keeping the inflation rate exactly equal to the inflation target: In booms the inflation rate is larger and in recessions the inflation rate is smaller than the target rate. 2% 3% => No deflation in recessions if the inflation target is “high enough”! Prof. Dr. Rainer Maure

  11. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB Inflation Rate UPSWING UPSWING DOWN-SWING DOWN-SWING 3% B O O M B O O M R E C E S S I O N R E C E S S I O N 2% Inflation Target (=Long Run Average) = 0% Actual Realization of Inflation 1% Time 0% 2% => Deflation in recessions if the inflation target is 0% ! 3% => Danger of deflation spirals! Prof. Dr. Rainer Maure

  12. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB Inflation Rate UPSWING UPSWING DOWN-SWING DOWN-SWING 3% B O O M B O O M R E C E S S I O N R E C E S S I O N 2% Inflation Target (=Long Run Average) = 0% Actual Realization of Inflation 1% Time 0% 2% 3% Deflation spirals can boost recessions! Prof. Dr. Rainer Maure

  13. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Psychological effects in the presence of sticky nominal wages : • One assumption of the neoclassical model (Chapter 2.1.) was the “absence of money illusion”. This means i.a. that an increase of goods prices P↑ causes workers to demand an immediate increase of nominal wages w↑, such that real wages stay constant w↑ / P↑. • However, laboratory experiments show that real-world people are not always that rational. If asked, what is more fair: (a) A decrease of nominal wages by 2% given 0% inflation or (b) an increase of nominal wages by 2% given 4% inflation? most people prefer option ( ). • Since there is always structural change in the economy, which urges a couple of industries to reduce their real wage in order to avoid dismissals (s. Chapter 5.1.3.5. “Mismatch Unemployment”.), an inflation rate above zero can increase the “social acceptance” of such real wage reductions. Critics argue however that this implies a deception of workers – an exploitation of mental shortcomings. Prof. Dr. Rainer Maure

  14. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • The possibility to generate negative real interest rates • Imagine the inflation rate were equal to 5 % and the interest rate you have to pay for a credit were equal to 2%. • What kind of deal would be profitable under such conditions? • What would happen with the total demand for goods, if everybody would act this way on average? • How would this affect the business cycle? Prof. Dr. Rainer Maure

  15. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • The possibility to generate negative real interest rates • In order to create the above incentive, the nominal interest rate it must be lower than the inflation rate (Pt+1- Pt) / Pt: it<(Pt+1- Pt) / Pt • The lowest level of the nominal interest rate a central bank can reach with normal monetary policy is it= 0 (In this case the central bank must offer money credits at an interest rate of zero). • Consequently at an inflation rate of zero, (Pt+1- Pt) / Pt = 0, it is notpossibleto create it<(Pt+1- Pt) / Pt = 0 • Therefore in order to have the possibility to push the nominal interest rate below the inflation rate, the inflation rate must be larger than zero! Prof. Dr. Rainer Maure

  16. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • The possibility to generate negative real interest rates • If the nominal interest rate (e.g. 2%) is lower than the inflation rate (e.g. 5%), the “real interest rate” is negative (e.g. -1%), because the real interest rate is defined as: real interest rate = nominal interest rate ./. inflation rate rt= it ./. (Pt+1 - Pt) / Pt => -3% = 2% ./. 5% Prof. Dr. Rainer Maure

  17. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • However, also a couple of reasons for an inflation target equal to zero are in the debate. The most important are: • Inflation increases the costs of holding money. • Inflation increases the real tax burden • Wrong decisions caused by money illusion • These arguments too are heavily disputed – there exists no unanimity on these issues! Prof. Dr. Rainer Maure

  18. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the costs of holding money. • How much money do you hold in your moneybag? • How much money would you hold, if the inflation rate would be 10%? Prof. Dr. Rainer Maure

  19. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the costs of holding money. Money All money spent in 6 days => New visit at the ATM… 100 € withdrawn at the ATM => Transaction costs… Money spent per day Time Prof. Dr. Rainer Maure 6th day 1st day

  20. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the costs of holding money. Money 50% reduction of money holdings because of higher inflation 50 € withdrawn at the ATM All money spent in 3 days => New visit at the ATM… => Transaction costs… Money spent per day Time Prof. Dr. Rainer Maure 1st day 3rd day

  21. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the costs of holding money. Money 50% reduction of money holdings because of higher inflation 50 € withdrawn at the ATM =>2 visits at the ATM in 6 days! => Double as high transaction costs! Money spent per day Time => Inflation increases the costs of holding money! Prof. Dr. Rainer Maure 6th day 1 Day

  22. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden: • Numerical example: (a) The capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π = 2%. What is the real capital income tax rate? (b)The capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π =0%.What is the real capital income tax rate? Prof. Dr. Rainer Maure

  23. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden: Prof. Dr. Rainer Maure

  24. Prof. Dr. Rainer Maure - 26 -

  25. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden: (a)The nominal capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π=2%. What is the real capital income tax rate? => Prof. Dr. Rainer Maure - 27 -

  26. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden: (b)The nominal capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is π=0%. What is the real capital income tax rate? => Prof. Dr. Rainer Maure - 28 -

  27. The effect of inflation on the real tax rate is the higher the lower the real interest rate. Prof. Dr. Rainer Maure

  28. As this calculation shows, the real tax rate can reach levels above 200% for assets that pay only a low real interest rate. In this case the real tax payment is higher than the real return so that the investor suffers from a real loss! Prof. Dr. Rainer Maure

  29. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden: • How to prevent this effect of inflation on the real tax burden? • Set the inflation target equal to zero! • Tax not the nominal income but the real income: Prof. Dr. Rainer Maure - 31 -

  30. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden • In the above example, the capital income tax rate is constant. • For other kind of incomes, the tax rate increases however with the nominallevel of income (tax progression). • As a consequence, if a household’s nominal income grows in order to compensate the household for inflation such that its real income stays constant, the household will have to pay more taxes – even if the household’s real incomes stays constant. • This is effect is called “bracket creep” (“Kalte Progression”). Prof. Dr. Rainer Maure

  31. Marginal income tax determined by tax law => Changing tax rate for every single Euro of income Resulting average tax rates Example: For a yearly income of 20000 Euro the average tax rate is 14,56% Prof. Dr. Rainer Maure

  32. Marginal income tax determined by tax law => Changing tax rate for every single Euro of income Resulting average tax rates Example: For a yearly income of 20400 Euro the average tax rate is 14,83% Prof. Dr. Rainer Maure

  33. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden • The following numerical example reveals this effect: • A worker with an income of 20 000 € receives as a compensation for an inflation rate of 2% an increase of his nominal wage of 2%. According to the German income tax tariff, his income tax rate at the income of 20 000 € was equal to 14,56%. After the increase of his income, the tax rate is equal to 14,83%. (a) Calculate the real increase in the household’s income before tax. (b) Calculate the real percentage increase in the tax burden. • The following diagram applies the formula for the growth rate of the real income tax for an inflation rate of 2% and 4% to the average income tax rate according to the German income tax tariff: Prof. Dr. Rainer Maure

  34. Prof. Dr. Rainer Maure

  35. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden • It is of course possible to argue that it is not monetary policy that is to be blamed for this effect but the tax system. • Countries like Switzerland allow their citizens to deflate their nominal incomes by the inflation factor (=divide by factor [1+inflation rate] ), before their tax rate is determined. • This way, the part of income growth that compensates only for inflation, is not taxed. • As a result, if incomes grow only by the inflation rate, the real tax burden stays constant. Prof. Dr. Rainer Maure

  36. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Inflation increases the real tax burden • It is of course possible to argue that it is not monetary policy that is to be blamed for this effect but the tax system. • Countries like Switzerland allow their citizens to deflate their nominal incomes by the inflation factor (=divide by factor [1+inflation rate] ), before their tax rate is determined. • This way, the part of income growth that compensates only for inflation, is not taxed. • As a result, if incomes grow only by the inflation rate, the real tax burden stays constant. Prof. Dr. Rainer Maure

  37. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Wrong decisions caused by money illusion • Theoretically most people understand the consequences of inflation. However, in cases where they have to decide fast and base their decision on a gut level they very often make big mistakes. • These mistakes would not appear if the inflation rate where zero. The following experiment illustrates the problem: • Alex, Berta und Charly inherit 200 000 €. All invest their money in a house. After 10 years they resell their houses: • Alex lives in a country, where prices on average have fallen by 25%, and receives a selling price, which is 23% lower than his purchase price. • Berta lives in a country with zero inflation and receives a selling price that is lower than 1% of her purchase price. • Charly lives in a country, where prices on average have grown by 25% and receives a selling price, which is 23% higher than its purchase price. Prof. Dr. Rainer Maure

  38. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • Wrong decisions caused by money illusion • Rank the profitability of the investments according to their real return: • The consequences of such wrong decisions would not happen in case of a zero inflation rate. • If one could be sure today that in 10 or 20 years the price level would be the same as today, many financial decisions would be become easier to make. Prof. Dr. Rainer Maure

  39. 6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB • To sum up: • In order to decide, whether the inflation target of a central bank should be larger than zero the pros and cons of such an inflation rate must be evaluated. • This is a complex task and can lead to different conclusionsdepending on the subjective weights one applies to the various arguments. • The evaluation that the advantages of a “not too high but constant inflation rate above zero" outweigh the disadvantages is internationally widespread a often called the “consensus point of view”. Prof. Dr. Rainer Maure

  40. Macroeconomics 6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB Prof. Dr. Rainer Maure

  41. 6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB • The ECB Council decides about the application of the monetary policy instruments of the ECB. • The council regularly meets every 2nd Thursday. In normal times, monetary policy decisions are made every 6 weeks. • The members of the council decide by majority vote. In case of a standoff the president decides. 6 Members of the ECB Board Nineteen …plus Slovenia, Malta, Cyprus, Slovakia,Estonia, Lettland, Lithunia Prof. Dr. Rainer Maure

  42. 6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB • What kind of instruments does the ECB use to achieve the decisions of the ECB Council? • The ECB uses the supply of money to commercial banks as its instrument. • There are two kind of operations that are normally used to supply money to commercial banks: • Refinancing Operations • Main Refinancing Operations • Longer Term Refinancing Operations • Standing Facilities: • Marginal Lending Facility • Deposit Facility Prof. Dr. Rainer Maure

  43. 6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB • Refinancing Operations 1.1. Main Refinancing Operations • Every workday Monday, an online-auction takes place where about 800 commercial banks bid for money credits with a maturity of one week. • Banks must provide fixed rate securities (of high credit-worthiness) as collateral. 1.2. Longer Term Refinancing Operations • …basically identical to Main Refinancing Operations with exception of the maturity: 3 - 6 months. • The standard auction (deviations are possible!) is based on an action mechanism called „American Interest Tender“. Prof. Dr. Rainer Maure

  44. American Interest Tender Maximum Bid Planed Allotment Volume i Marginal Rate Minimum Bid Rate imin Credit Volume in € Bids without Allotment Bids with Allotment Prof. Dr. Rainer Maure

  45. Prof. Dr. Rainer Maure

  46. 6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB • Standing Facilities are intended to smooth the development of the interest rate on the interbank market. Therefore, they can be steadily used by commercial banks: 2.1. Marginal Lending Facility • „Overnight Credit“: Commercial banks can get a short-run credit in case of an unexpected liquidity shortage. They have to pay a special interest rate called “marginal lending rate” 2.2. Deposit Facility • „Overnight Saving“: Commercial banks can deposit money at the ECB in the short run in case of an unexpected liquidity glut. They receive a special interest rate called “deposit rate”. Prof. Dr. Rainer Maure

  47. 6. The Monetary Policy of the ECB6.2. The Policy Instruments of the ECB • The impact of the ECB interest rates on the interbank credit market: • Marginal Lending Rate = Main Refinancing Rate + 1% (currently + 0,25%) • Deposit Rate = Main Refinancing Rate ./. 1% (currently -0,4%) • As the following diagram shows, the EONIA rate (= the interest rate on which banks lend overnight money among each other) lies always between the Marginal Lending Rate and the Deposit Rate. Prof. Dr. Rainer Maure

  48. Source: ECB Prof. Dr. Rainer Maure

  49. Quelle: ECB 1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft 2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft Prof. Dr. Rainer Maure

  50. Macroeconomics 6. The Monetary Policy of the ECB 6.1. The Policy Target of the ECB 6.2. The Policy Instruments of the ECB 6.3. Money Creation by Commercial Banks Prof. Dr. Rainer Maure

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