Monetary Policy in the EU
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- The ECB responds to aggregate levels of inflation and unemployment, not individual country levels.
- The ECB does not respond to this individual member’s inflation or unemployment situation because it only looks at the aggregate level of inflation. One member does not have enough influence on the aggregate level to induce the ECB to conduct monetary policy.
- Even if the shock is big enough or the member is big enough to affect the aggregate levels of inflation and unemployment, the response by the ECB would not be as strong as it would have been if the member could have conducted its own monetary policy.
- Because the member cannot conduct its own monetary policy, if it wants to try and influence inflation or unemployment in its own country it can only use fiscal policy. In times of negative shocks this can lead to budget deficits. See fiscal policy in the EMU.
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.
- All central banks are not the same. Some central banks, such as the German central bank before monetary unification, have a reputation as being very good at keeping economic fluctuations under control (especially inflation. Others, such as the Italian central bank before monetary unification, do not have as good a track record in controlling fluctuations (especially inflation). If a country’s central bank has a good reputation, its policy is said to be credible. The country with a credible central bank will attract international businesses who like the certainty of low inflation fluctuations. When the ECB was formed, it adopted the German model and put a strong emphasis on price stability. Once Italy joined the EMU, they automatically gained the advantages of having a central bank with a reputation for price stability. Thus increasing the attractiveness of doing business in Italy.
- Smaller countries are more susceptible to exchange rate fluctuations. They export and import much more relative to their size than a large country. Changes to exports and imports, which happen often in smaller economies, cause frequent and sometimes large fluctuations in the exchange rate. Joining a monetary union brings the advantages of sharing a currency across a group of countries, effectively increasing the economic size of the small country. Big economies, and thus a small country in a monetary union, have less frequent and smaller exchange rate fluctuations. Reducing exchange rate fluctuations has the advantage of increasing transparency, lowering transaction costs , and improving trade and investment.