The European Central Bank and European economies in global context

Essay 2005 25 Pages

Economics - Monetary theory and policy





I. Diary of Events of the European Central Bank

II. Annotated Bibliography

III. References

In January 1999 eleven countries of the European Union locked their foreign exchange rate to the Euro and committed themselves to annul their own currency in favour of the Euro in the year 2000 (Bradley S and Whittaker J, 2000, Industrial Relations Journal, 31, 4, 261). Of particular interest and complexity are the relationships between countries within the euro zone and other economies worldwide. The relationship between the European economies and the European Central Bank (ECB) and its consequences in global context is a central issue in this report. Therefore, the previous research about the ECB has concentrated on its influence towards European and other global economies. The members of the current euro zone are: France, Germany, Italy, Austria, Belgium, Finland, Greece, Luxembourg, the Netherlands, Portugal and Spain. Apart from this, Denmark, Sweden and the United Kingdom are members of the European Union, which have not adopted the euro yet. These three countries are European economies even when they play another role in global context because of their own currency: British Pound, Danish Krone and Swedish Krona. Accordingly, the remainder of this paper is divided into four sections, reasons for establishing the ECB and its objectives, how decisions of the ECB concerning the interest rate may influence economies worldwide, a briefly annotation of advantages and disadvantages for members of the euro zone and a conclusion including a short outlook.

The monetary policy is implemented by the European System of Central Banks (ESCB), insistence on the ECB and the national central banks of the member states. On the whole, the Treaty of the European Union defines the independence of the ECB and of the national central banks. The primary objective of the ECB is to ensure the price stability within the euro zone. Is this objective achieved there exist four subordinated objectives: “to define and implement the monetary policy, to conduct foreign exchange operations, to hold and manage the official foreign exchange reserves of the member states and to promote the smooth operation of payments system” (Howells P and Bain K, 2002, 475). As a “banker’s bank” central banks normally do not deal with the public. However, the banks, which deal directly with a central bank, pass the changes in the interest rate to their customers, the public (Rose P, 2003, 356). Central banks are always key financial institutions because they set the monetary framework within the financial and economic institutions are able to operate (Pilbeam K, 1998, 29). The ECB as an institution is the logical consequence for a consistent monetary policy in the whole euro area. If every single country in the euro zone creates its own monetary policy there would be many flows of money from one to another country by for example raising the interest rate in one country. This disequilibrium cannot be balanced by influencing the exchange rate because it is then the same in all countries of the euro zone. However, a monetary policy of one institution can always only be a policy for the average of the countries because in one country the situation might be completely different from another country within the euro area.

A very important factor of the reactions towards decisions of a central bank is the trust in its decisions. Nowadays, the trust in the ECB is very strong so its decisions normally have the effect they should have. Thus, the monetary policy of the ECB influences the European economies and other countries all over the world as well. However, this was not the case when the ECB was established because it was a new institution with no former experiences or reputation. So in that time the Euro felt dramatically versus the Dollar (Howells P and Bain K, 2002, 485). This situation has changed in the last years and the ECB has won the trust of the market participants from all over the world. How can the ECB then influence them?

All began with the image of Germany as a low-inflation country and a strong monetary policy of the Deutsche Bundesbank (Howells P and Bain K, 2002, 472). This reputation is partly transferred to the ECB which also has its headquarter in Frankfurt am Main in Germany. In addition, the Euro as the currency of most of the European Union’s members is now seen as a competitive currency to the US-Dollar. Generally, the ECB is able to influence the economies with the level of minimum required reserve, open market operations and standing facilities (Ayuso J and Repullo R, 2000, 1). However, these three methods to establish the ECB’s monetary policy are not the topic of this report which focuses on consequences of decisions concerning the interest rate. Obviously, a change in interest rate influences the above mentioned methods as well.

Therefore, a decision made by the ECB concerning the interest rate in the euro zone has an immediate effect to countries worldwide. The countries within the euro zone will react in the way it is expected, in fact, some countries stronger than others because the situation is obviously not the same in all countries of the euro zone. A decrease of the interest rate for example would lead to expenditure and more consumption in Germany where the economy is weaker at the moment. When a central bank makes decisions those have got a major influence on the economy because the cost and availability of credits changes, the volume and rate of growth changes, the financial wealth held in stocks, bonds and other securities holdings changes, the relative prices and currency exchange rate changes and the public’s expectation regarding future money, credit conditions and currency values changes, too. All these five changes are indispensable consequences of a central bank’s decisions and are also significant for the influence of the ECB towards European economies and economies worldwide. Finally, all these impacts can be influenced by changing the interest rate or changing the level and growth of reserves in the banking system (Rose P, 2003, 360).

To be more precise, decisions of the ECB mean the following for the European economies in global context. A change in the cost and availability of credits will influence the European economies directly because in the euro zone credits will be cheaper or more expensive and the public will spend or save more money. However, changes in the interest rate lead to changes in credit costs and influence outstanding economies as well. Has the interest rate been increased there will be a capital flow into the euro zone to make profit because of the higher interest rate and vice versa. A change in the financial wealth takes place when the interest rate decreases so that prices of bonds will increase which also increases the financial wealth of European and global investors in European bonds. A change in the relative prices of domestic goods and the currency exchange rate influences the importers and exporters within the euro area but also the importers and exporters outside the euro area. If the euro gets stronger it is more difficult for European exporters to sell their goods and easier for importers to buy their goods and vice versa for countries outside the euro area. A change of the public’s expectation regarding future money, credit conditions and currency values has consequences for domestic and foreign investors, as well. In addition, the ECB can influence the economies with its different tender procedures, too.

On the one hand there are many advantages for the members of the euro zone which follow from the monetary union: lower transaction costs, reduced exchange rate volatility and therefore less uncertainty, more price transparency and a better functioning internal market. On the other hand there are also costs like the loss of the exchange rate as an economic policy. This means that the member countries cannot change the price of their own currency any longer because it is the same to every single country within the euro area (Eijffinger S and de Haan J, 2000, 16-18).

Furthermore, the globalisation has reached the financial world and financial markets are working closer together than they did last decades. Investors and borrowers are not fixed to national markets any longer. Within the euro zone investors and borrowers are able to work with their money within different countries in only one currency, the euro. This is a rare phenomenon and for example not comparable to the United States of America (USA), even when the US-Dollar is the currency for all states of the USA. The European countries are different from those because of their own language, culture and traditions.

In conclusion, there is no final clarification if the Euro will get more influence on the world affairs than the US-Dollar. However, it is possible because the last years after establishing the Euro have shown a steep increase of reputation. It is widely accepted that the Euro can be seen as a competitive currency towards the US-Dollar. Nowadays, the ECB is leader in terms of transparency comparing other central banks because of its transparent monetary policy and its immediate press conferences after important meetings (Trichet J-C, 2004, 27). Consequently, there are pros and cons for the euro zone. Positive arguments for the euro zone are lower interest rates for countries as Italy, a better ability to intersect shocks as 9/11, bigger deals are possible because of an functional capital market and rising reputation of the Euro as a reserve currency (February, 2004 19.7 % of central bank holdings). On the other hand negative aspects against the Euro are its strength for exporters who want to compete with China, furthermore, the risk that a possible financial crisis in one country will automatically infect all countries within the euro zone and a unique monetary policy cannot be adequate for every single country (Ewing J, Reed S and Kline M, 2005, 3936). Discussions about the end of the euro zone at the beginning of this year have finished again but of course topics like this will repeatedly reduce the market price of the Euro again.



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525 KB
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University of East London
First class (72%)
European Central Bank



Title: The European Central Bank and European economies in global context