Monetary Policy in the EU

key terms

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asymmetric shock

economic fluctuations

fiscal policy

interest rate

monetary union

net exports

price level

transaction cost

weighted average

Challenges:

In addition to the problems associated with conducting monetary policy in general, there are specific problems when conducting policy in a monetary union.

Example:

Assume that salmonella is found on Austrian tomatoes. As a result the demand for Austrian goods falls and Austria’s aggregate demand curve shifts down (see economic fluctuations). This leads to lower inflation and higher unemployment. Assume that the rest of Europe does not experience the same shock. When the ECB looks at inflation they may see a slight fall in aggregate European inflation, but decide to do nothing about it because the change is so small. The Austrians would prefer that the ECB lower interest rates to decrease unemployment. The ECB is afraid that if it does, the aggregate affect will be higher inflation across the EMU. As a result of monetary inaction, the Austrian government may decide to use fiscal policy. They could increase government spending in order to lower unemployment. The increase in government spending worsens the budgetary position and could even lead to a budget deficit.

Advantages: