Differences in the Monetary Policy Transmission Mechanism within the European Monetary Union: Germany and Italy

Contents

I. Introduction
I.2 Structure

II. Transmission Mechanism
II.1 Endogenous money and the credit market
II.2 The basic approaches
II.3 The IS-LM-model and the interest rate structure
II.4 Interest-Rate Channels
II.5 Credit Channels
II.5.1 Bank-Lending Channel
II.5.2 Balance Sheet Channel
II.6 Exchange rate channels
II.7 Equity price channels
II.8 Expectations

III. The ECB and the Monetary Union
III.1 The Currency Area
III.2 Monetary Policy Instruments of the Eurosystem
III.3 Risks and causes of asymmetric transmission

IV. The Transmission Mechanisms of the European Monetary Union
IV.1 Euro area in the aggregate
IV.2 Aspects of Monetary Transmission in Italy
IV.2.1 Banking sector
IV.2.2 Investment and production
IV.2.3 Inflation
IV.3 Aspects of Monetary Transmission in Germany
IV.3.1 Banking sector
IV.3.2 Investment and production
IV.3.3 Inflation
IV.4 Convergence perspectives
IV.4.1 Financial sector
IV.4.2. Real sector

V. Conclusion

References

I. Introduction

The European Central Bank^[1] is in charge to conduct monetary policy for a growing number of nations, participating in the European Monetary Union. This joint enterprise is still young, but followed decades of increasing cooperation and integration after the Second World War. However, the question remains how suitable a shared monetary policy is for a number of different economies.

Today, most central banks put emphasis on price stability as medium-term goal, for this is the best way to stabilise expectations and to promote sustainable growth. A precondition for the successful conduct of monetary policy is that monetary impulses are transmitted throughout the whole currency area in a symmetric way. Therefore, central banks need to assess the timing and magnitude how interest rate movements affect the economy and through which channels this mechanism works. This allows the central bank to use their policy instruments at the right time and with the right intensity.

Information about the characteristics of the monetary transmission process in EMU-countries^[2], especially about national differences, has important lessons for the effective conduct of monetary policy. Consequently, asymmetric monetary transmission would be able to weaken the position of the European Central Bank and has a negative impact on the economy.

This paper deals with the question of asymmetric transmission in the Euro-area. It involves information about the characteristics of transmission channels in EMU countries, the different stages of transmission where asymmetry or convergence might occur and the perspectives for the future development of the European transmission mechanisms. The objective is to find out about asymmetries in monetary policy transmission and their consequences. This paper answers the question if there are major drawbacks for participating economies possible or if the Euro will catalyse European integration without negative side effects.

I.2 Structure

The monetary transmission mechanism has been examined in a wide range of theoretical literature. The first chapter provides a balanced overview on the current views on transmission channels, disregarding the intricacies. It implies a brief introduction to the transmission process in general, the different stages of transmission, the IS-LM model, the terms of various interest rates, endogenous money and non-neutrality of money.

The second chapter provides information about the institutional framework of the European Monetary Union (EMU), connecting the theoretical to the main part. In this context, the characteristics of EMU as a currency area, the framework of the Eurosystem and the causes and risks of asymmetric transmission are outlined.

The third and main part handles the question of differences in the transmission mechanism in practice. In the first step, this is the transmission mechanism of the aggregate Euro-area economy will be outlined. A special consideration will be given to selected aspects of monetary transmission in Italy and Germany. Since a differentiation between transmission channels in practice is not adequate, the financial sector will represent an intermediate stage of transmission and the real sector exemplarily the final stage. In the last step, the future perspectives for monetary transmission in Europe will be outlined. The paper is based on the most recent literature and therefore gives a very up-to-date insight to the topic and discussion.

II. Transmission Mechanism

A major long-run goal for central banks is price stability. Beside that, monetary policy can promote a variety of secondary goals that might be targeted in a more discretionary way. Among these goals is exchange rate stability, promotion of growth and employment, the fight against deflation, or in general short-term impulses to economic activity. Multiple goal strategies usually work with a clear hierarchy in favour of price stability. The degree to which central banks communicate their actual goals and strategies to the public is a political decision.

To achieve these policy goals, monetary policy has to influence economic variables. The basic strategy they use is to steer operative targets, like the monetary base or the inflation rate. Anyway, the primary policy instrument is to manage the money market interest rate^[3]. Up to this point, it would be the easiest to assess the relationship between the operative target and the policy goal to design a policy strategy. Unfortunately, the relationship between both is neither direct nor constant, which makes the examination of the intermediate stages necessary. The strategy and the operative target have to fit to the stage of economic development, the whole economical and financial market framework and the monetary policy regime. Most of all, the strength of how monetary policy is transmitted, is depending on economic activity. In general, transmission channels effect prices and production and they are different in the way the processes are working.^[4]

The knowledge about the transmission process of monetary policy is yet incomplete. Theoretical examinations about the topic are still divided and the observations of practice supported by empirical studies have not found a predominant channel guaranteeing policy goals to be achieved. One reason for that is the dynamic and complexity of today’s open economies. Economic variables, feedback processes and varying time lags influence the monetary transmission process. As a simplification, many textbooks describe the transmission process as a black box.^[5]

illustration not visible in this excerpt

Illustration based on the writings of Görgens/Ruckriegel/Seitz (2004)

The inflation rate, as most important late-indicator of monetary policy, is less depending on monetary policy actions in the short run. Other influence factors like wage developments, fiscal policy or external shocks might dominate the price level for a while. In the long run, monetary policy will be transmitted to the inflation rate, but without a stable relation. The central bank is capable to restrict the economic activity and contain inflation in the long run, but possibly not to stimulate them, when the economic circumstances and expectations have worsened.^[6] Monetary Policy is affecting the economy in an asymmetric way so that relative advantages and disadvantages change the income structure until all kinds of prices are affected. This is obvious for savings and wages, but also for debts and the net worth of assets. As a consequence, monetary policy can give real impulses to economic activity until the price level is affected. Therefore, it is possible to give short-term impulses to economic activity, but impossible to fuel growth and employment steadily.^[7]

Central bank policy involves the insecurity whether the applied instruments will have the desired effect, if the assessment of the situation was right and what other influences will change the outcomes.^[8] Therefore, the most common objective is to stabilise prices and expectations and to promote sustainable growth in the medium and long-term.^[9]

Money needs time to pass through the economy and to impact towards the desired policy goals. In the traditional view, the operative target is impacting on the financing conditions in the first stage of transmission. These financing conditions influence the pattern of expenditure that makes marginal investments profitable or unprofitable. In the last stage, the changing expenditures are affecting the production and prices. Therefore the transmission process is not reduced to the financial sphere, which is the intermediate stage of transmission. Real variables like investment, consumption, employment and production the immediate determinants of the price level and they represent a part of the economy, which is more independent from monetary policy.^[10]

II.1 Endogenous money and the credit market

The mechanism how money is supplied and demanded is important for monetary transmission. However, theory is ambiguous what mechanism is at work.

According to the Quantity Theory of Money, money supply is exogenously given by the central bank. This approach assumes a proportional relationship of a monetary aggregate and the price level. In case of a monetary expansion, the central bank can lower the interest rate that matches with a higher demand at the price of increasing inflation. Under the assumption of open production capacities, the given interest rate determines a certain capacity utilisation and inflation rate, but leaves the real price relationships unchanged. To explain the process of transmission, this model uses the picture of “Helicopter-money” that falls from the sky. This approach is reasonable in a monetary environment of closed economies based on precious metal and dependent central banks. Despite these limitations, the Quantity Theory is able to explain periods of hyperinflation and long-term price trends in history. Exogeneity is therefore a historical description of closed monetary systems.^[11]

The assumption that money is exogenously given is closely connected to the view of money neutrality. In the most basic approach, money does not change the real economic variables and functions as a numéraire to simplify economic transactions. The question follows what happens if individuals are not acting accordingly. Individuals connect the value of money to individual expectations of the future and these amounts are not necessarily the same as the actual amounts of money. In a dynamic economic environment and a multitude of subjective preferences, it is common to hold and to horde money, which is unlikely for a simple numéraire. Additionally, a similar monetary policy shift might have different effects based on the economic circumstances. A monetary impulse is slowly and heterogeneously injected to the economy with real economic implications. From a microeconomic view, inflexible prices, contracting and heterogeneous financial markets have short run effects, changing the relative composition of income. The short-run effects of asymmetric transmission do not vanish in the long run, but sustain and build the temporary basis for the future economic development. As a consequence, money does not necessarily have to be neutral.^[12]

Despite this controversy, the potential of monetary policy to steer the economy is limited. The dangers of central banks unsustainable involvement into economic affairs supported the view of money neutrality as a rule of thumb and a long-term orientation of policy strategy.

Nowadays, high volumes of a currency are circulating abroad, which impact on money supply. In a monetary environment of independent central banks, open economy, paper money and well-developed financial markets, some additional features of the transmission channels have to be included. Considerably rising monetary aggregates without corresponding inflation rates suggest that money is supplied not only by central banks.^[13] A more adequate view is that money is supplied almost exclusively through credit. The influence of the central bank is limited to the money market interest rate level at which the credit market can decide to supply and demand money with variable volumes.^[14] As a consequence of deepening financial markets, money supply gets increasingly endogenous.^[15]

The credit market is the place where interest rates are determined by the equilibrium of money supply and demand. Commercial banks that work as financial intermediaries provide money mainly in form of loans to the economy. This approach respects the influence of different kinds of interest as well as a magnitude of real and financial assets that impact on transmission, because they are complementary or substitutable in the balance sheets and portfolios of economic actors.^[16]

The importance of the credit market has implications for the transmission process. The delayed impact of monetary policy is due to the supplying process that works through financial markets and especially via the banking sector. The following schematic showing gives a simplified overview:

illustration not visible in this excerpt

(Modified version based on Samuelson1973, p. 316)

Commercial banks are demanding refinancing facilities from central banks and supplying credit to non-banks. The interface between banks and non-banks is the most important in forming the credit market and in terms of the impact on the real sphere.

Investment and consumption are influenced by the relationship of interest rates on the credit market towards the set of real interest rates like return on investment, marginal productivity of capital, natural rate etc. This relation can be simplified as the interest rate denominated in money and the interest rate in terms of a basket of goods. Depending on various kinds of interests and interest sensitivities, the impact of monetary policy is heterogeneous. Another important component of money demand is the changing and dynamic forms of expectations that impact on the value of money.^[17]

II.2 The basic approaches

There is consensus about some aspects of the monetary transmission mechanism. First that the central bank is able to control the supply of one asset, which is central bank money, financial institutions are depending on. The second concerns the existence of nominal rigidities in the labour as well as in the goods markets that prevents the price level to fully adjust in the short term. Frictions of the financial sector also count as rigidity and imperfect market condition. Finally, the central bank is able to steer the money market interest rate.^[18]

The debatable components of the transmission mechanism are the processes through which the central bank influences the behaviour of firms and households. Towards this question, three basic views exist:^[19]

- The traditional view (money view) emphasises that monetary policy is impacting on the long-term interest rates and exchange rates. These changes are transmitted altering the efficiency of marginal investments and lead to inter-temporal shifts in consumption and a change in consumption patterns. The exchange rate amplifies the effect by a change in the foreign trade balance and price pressures through traded products. Imperfections and externalities are disregarded in this view, since they are expected to vanish in the long run.^[20]
- The credit channel (lending view) focuses on financial market imperfections that prevent monetary policy to have a smooth and immediate effect. Asymmetric information and the cost of contract enforcement generate a difference between external and internal financing. These kinds of market imperfections drive a wedge between the financial constraints of the borrowers and the expected return of the lenders, which is called the external finance premium. This premium is assumed to amplify interest rate movements of the central bank.^[21]
- The cost channel includes the effects of monetary policy on supply factors. Since firms have to borrow and invest before they are able to receive any revenue, any interest rate shift will impact on investment and labour demand. Interest rate increases will therefore be followed by higher production cost and a decline in output.^[22]

These three basic approaches to the transmission mechanisms have to be seen as complementing each other and not as alternatives. At the core is still the traditional interest rate channel, which is amplified by a number of secondary effects.^[23]

II.3 The IS-LM-model and the interest rate structure

To explain the basic transmission mechanism, textbooks use the macroeconomic IS-LM model. Expansionary monetary policy leads to a decreasing interest rate level and to an increase aggregate demand. The IS-LM model assumes the economy to not work at full capacity, so that nominal changes in the income level have also real effects. How strong these effects are, is depending on the magnitude of the monetary impulse and on the degree of interest elasticity of demand. In the following schematic showing, a monetary expansion leads to a shift in the LM-curve (LM1® LM2). The IS-curve remains unchanged (ceteris paribus) and intersects with LM2 at a new equilibrium, which is identical with a lower interest rate (i2) and higher income (Y2), respectively:^[24]

illustration not visible in this excerpt

The graph shows the most simplified version in the way that money demand and goods demand are interest rate elastic. More close to reality, various shapes of the curves are likely, which make alternative interpretations possible. The model shows the monetary effects in the short-term under open production capacities without longer-term price effects.

The model implicates a set of assumptions. It is assumed that the central banks determine money supply exogenously. The microeconomic stations of transmission are not visual in the model. Since the IS-LM model is a very simplified view to the transmission process, it disregards market frictions that might contradict monetary policy. The interest rate (i) is assumed to be representative for any interest, demand is responding to.^[25]

Including the financial sector and different kinds of interest rates, the process of transmission will be extended. In the first stage, interest rate movements influence the refinancing cost of the financial sector. Within the set of monetary policy instruments the main refinancing facilities play an important role. The interest rate, at which commercial banks can refinance themselves with the central bank, is having a direct impact on money market interest rates. Commercial banks react to movements of the refinancing facilities soon by adapting the inter-bank money market rates. Through arbitrage processes the money market interest rate is impacting on the capital market interests and the stock market. To which degree this has influence on investment depends on the relation of long to short-term refinancing alternatives. The whole set of nominal interest rates will usually move in the same direction, although money market interests are lower and more volatile than capital market interest rates. Different maturities work as a buffer to monetary policy since the money and capital markets are no perfect substitutes.^[26] Beside the actual money market interest rates, capital market interests are depending on several variables e.g. fiscal situation, savings, growth, exchange rate, foreign interest rate, expected inflation and liquidity premium.^[27]

After monetary policy is transmitted to the whole set of interest and also exchange rates, financial prices interact with investment and consumption. Important feature of the transmission process is, how other asset prices beside interest rates react and function as substitutes for individual portfolio changes. Wages and prices adjust and feed back to the financial system, inducing second round effects on interest rates. This is the last stage of the transmission process, which is the most important for price developments.^[28] At this stage other factors like fiscal policy, economic activity or expectations might exert a bigger share of influence on the price level. E.g. increasing insecurity about the future can cause a contraction effect. In this case, market participants would increase liquidity in their portfolio and decrease investment and consumption. As noted before, the relation of different kinds of interests gives the main connection of monetary and real sphere. On the monetary side there is the interest rate level of the credit market, which can be described as money interest. On the other side, there is the rate of return on real assets, which is also displayed by the internal rate of return, efficiency of capital or “Tobin’s q”.^[29]

The process of how the central bank interest rate is influencing the economy is explained by a set of related channels. The interest rate channel, in the narrow sense, is closely related to the IS-LM model. All other channels are somehow related to the interest rate channel, and partly follow a microeconomic approach. The credit channels, exchange rate channel, and asset price channels account for a number of different effects, like second round effects, wealth, liquidity and substitution effects, that impact on monetary transmission. The following will give a more differentiated overview.

II.4 Interest-Rate Channels

The traditional interest rate channels are the basic view of how monetary policy influences the interest rate level and the economy. Changes in the central banks money supply lead to a disequilibrium on the money market and a shift in the interest rate, which moves to a level matching the IS-curve at a different income level.

The following schematic showing of monetary expansion is oriented on the IS-LM model. Increasing money supply by the central bank (M ­) leads to a decrease in interest rates (i ¯). Investment spending is responding to the cheaper financing conditions (I ­), which stimulates the economy through higher aggregate demand and output (Y ­):^[30]

illustration not visible in this excerpt

Illustration by Mishkin (1996: p. 2)

Important feature of this simplification is the emphasis on the real long-term interest rate to be influenced by monetary policy shifts. It assumes that a shift of the nominal short-term interest rate results in a shift in real interest rates. The corresponding change of the real short-term rate leads to a proportional fall of long-term interest rates. The real long-term interest rate is considered to have a major impact on investment spending of firms. With a shift of real interest rates, the real cost of capital changes, which is also called the cost of capital channel). In addition, household’s expenditure on durable goods and housing that is directly or indirectly related to the interest rate can be counted to investment. Therefore, the interest rate channel states that monetary policy is directly impacting on the real long-term interest rate and influence firms and households investment decisions.^[31]

[...]

^[1] Hereafter referred to as ECB

^[2] Countries of the Economic and Monetary Union/Euro-area countries

^[3] Heine/Herr (2004): p. 78

^[4] Bofinger/Reischle/Schächter (1996): p. 241-248

^[5] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[6] Heine/Herr (2004): p. 82

^[7] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[8] Hallensleben (2002): p.17

^[9] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[10] ibid .

^[11] Bofinger/Reischle/Schächter (1996): p. 550-554

^[12] Streissler (2002): p. 65-86

^[13] Bofinger /Reischle/Schächter (1996): p. 550-554

^[14] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[15] Streissler (2002): p. 65-86

^[16] Samuelson1973, p. 291-316

^[17] Bofinger /Reischle/Schächter (1996): p. 556-557

^[18] Els/Locarno/Morgan/Villetelle (2001): p. 9-13

^[19] ibid .

^[20] Els/Locarno/Morgan/Villetelle (2001): p. 9-13

^[21] ibid .

^[22] ibid .

^[23] Els/Locarno/Morgan/Villetelle (2001): p. 9-13

^[24] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[25] Görgens/Ruckriegel/Seitz (2004): p. 271-275

^[26] ibid .: p. 275-283

^[27] Kaehler/Korn (1995): p. 70-72

^[28] Görgens/Ruckriegel/Seitz (2004): p. 275-283

^[29] Bofinger /Reischle/Schächter (1996): p. 554-556

^[30] Mishkin (1996): p.1-4

^[31] Mishkin (1996): p.1-4