Lecture 10Lecture 10

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

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Optimum Currency Area Optimum Currency Area (OCA)(OCA)

The economic theory examining the The economic theory examining the necessary and desirable characteristics of necessary and desirable characteristics of countries economies for membership in a countries economies for membership in a monetary union is monetary union is the theory of the the theory of the optimum currency area (OCA)optimum currency area (OCA)..

The theory was introduced and popularized The theory was introduced and popularized by Robert Mundell (1961), Ronald by Robert Mundell (1961), Ronald McKinnon (1963), and Peter Kenen (1969).McKinnon (1963), and Peter Kenen (1969).

Robert Mundell received the Nobel Price in Robert Mundell received the Nobel Price in Economics in 2000, in part for his Economics in 2000, in part for his contribution to OCA.contribution to OCA.

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Costs and BenefitsCosts and Benefits Key question:Key question: Is the economy of the candidate Is the economy of the candidate

country characterized by relatively stable or rising country characterized by relatively stable or rising prices and wages?prices and wages?

The formation of a monetary union results in the The formation of a monetary union results in the loss of monetary and exchange rate policies.loss of monetary and exchange rate policies.

The loss of these policies is considered to be the The loss of these policies is considered to be the most important cost in joining a monetary union.most important cost in joining a monetary union.

These are the most useful policies to a country These are the most useful policies to a country experiencing internal shocks. These policies are experiencing internal shocks. These policies are used to fight recession or inflation.used to fight recession or inflation.

Robert Mundell’s initial contribution on the OCA Robert Mundell’s initial contribution on the OCA was developed within the IS-LM-FE model which was developed within the IS-LM-FE model which assumes constant prices. Rising prices can assumes constant prices. Rising prices can neutralize some or all of the positive effects of neutralize some or all of the positive effects of these two policies. these two policies.

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Are the shocks symmetric?Are the shocks symmetric? An exchange rate policy can be used by a non-An exchange rate policy can be used by a non-

member country to fight its way out of recession member country to fight its way out of recession caused by an caused by an asymmetric shockasymmetric shock..

So it is important to study the nature and expected So it is important to study the nature and expected frequency of asymmetric shocks for members of EU frequency of asymmetric shocks for members of EU countries.countries.

If most of the shocks are If most of the shocks are symmetricsymmetric, then member , then member countries can use policy related to the common countries can use policy related to the common currency to jointly deal with the shock.currency to jointly deal with the shock.

Asymmetric shocks can arise from differing financial, Asymmetric shocks can arise from differing financial, legal, and tax systems, and structural differences in legal, and tax systems, and structural differences in labor markets and institutions. Of course natural labor markets and institutions. Of course natural disasters within a limited geographic region are disasters within a limited geographic region are another cause of such shocks.another cause of such shocks.

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Integration and Shocks Integration and Shocks Increased intra-industry trade and further Increased intra-industry trade and further

economic integration should reduce country economic integration should reduce country differences which cause asymmetric shocks.differences which cause asymmetric shocks.

Empirical evidence suggests that business Empirical evidence suggests that business cycles in EU countries became more cycles in EU countries became more synchronized after the 1980s. Not all synchronized after the 1980s. Not all economists agree with this evidence.economists agree with this evidence. Paul Krugman (1993), drawing on U.S. evidence, Paul Krugman (1993), drawing on U.S. evidence,

argues that economic integration leads to regional argues that economic integration leads to regional concentration of industries. (e.g., automobile plants concentration of industries. (e.g., automobile plants in Michigan)in Michigan)

Obviously, regional concentration of industries could Obviously, regional concentration of industries could lead to asymmetric shocks.lead to asymmetric shocks.

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SeigniorageSeigniorage This is another potential cost to a monetary This is another potential cost to a monetary

union—the loss of the ability of the union—the loss of the ability of the governments involved to raise revenues governments involved to raise revenues through inflationary finance.through inflationary finance.

SeigniorageSeigniorage is essentially an is essentially an “undeclared “undeclared tax”tax” on money balances held by people and on money balances held by people and businesses.businesses.

When gov’t print too much money and cause When gov’t print too much money and cause inflation, the money already being held by inflation, the money already being held by the public loses value (purchasing power). the public loses value (purchasing power).

This loss of value is almost equal to the This loss of value is almost equal to the value of the newly printed money. This is value of the newly printed money. This is seigniorage. seigniorage.

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Seigniorage (2)Seigniorage (2) Generally speaking, most gov’ts relied heavily on Generally speaking, most gov’ts relied heavily on

seigniorage prior to WWII. Since then, most seigniorage prior to WWII. Since then, most industrialized countries have developed elaborate industrialized countries have developed elaborate tax systems to raise revenues. They have not had to tax systems to raise revenues. They have not had to rely as heavily on seigniorage.rely as heavily on seigniorage.

Southern EU countries consistently depended on Southern EU countries consistently depended on seigniorage for revenue, and have less well-seigniorage for revenue, and have less well-developed tax systems, and tend to inflate more developed tax systems, and tend to inflate more readily.readily.

This has caused some researchers to argue that This has caused some researchers to argue that Southern European countries should remain outside Southern European countries should remain outside the monetary union. the monetary union.

Other researchers disagree strongly, saying that the Other researchers disagree strongly, saying that the monetary discipline of the union would be a major monetary discipline of the union would be a major benefit to these countries.benefit to these countries.

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Overall Cost ConsiderationsOverall Cost Considerations Expected costs of the formation of a Expected costs of the formation of a

monetary union will be lower if labor markets monetary union will be lower if labor markets are flexible and if free labor mobility is high.are flexible and if free labor mobility is high. Regional unemployment can be offset by labor Regional unemployment can be offset by labor

moving to another region, and would not require moving to another region, and would not require direct policy intervention.direct policy intervention.

The expected costs of union would also be The expected costs of union would also be lower if the budgetary process is centralized, lower if the budgetary process is centralized, and the monetary union is vested with fiscal and the monetary union is vested with fiscal powers (i.e., a budget).powers (i.e., a budget). This would allow the union to direct loans or aid to This would allow the union to direct loans or aid to

countries or regions suffering asymmetric shocks.countries or regions suffering asymmetric shocks.

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BenefitsBenefits The most frequently mention benefits arise from The most frequently mention benefits arise from

the elimination of transactions costs. the elimination of transactions costs. These occur when businesses and consumers must These occur when businesses and consumers must

exchange currencies to purchase goods and services.exchange currencies to purchase goods and services. They occur when businesses invest abroad.They occur when businesses invest abroad. They occur when financial investors purchase foreign They occur when financial investors purchase foreign

securities. securities. Whether the reduction of such costs (risks) actually Whether the reduction of such costs (risks) actually

increases the volume of trade is uncertain.increases the volume of trade is uncertain. Ironically, while some firms may benefit the Ironically, while some firms may benefit the

reduction of such costs, it directly reduces the reduction of such costs, it directly reduces the income of banks and other financial institutions who income of banks and other financial institutions who sell services to deal with exchange rate problems!sell services to deal with exchange rate problems!

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Benefits (2)Benefits (2)

Price transparencyPrice transparency Expressing all prices within the union in Expressing all prices within the union in

terms of only one currency allows terms of only one currency allows everyone to compare prices more easily.everyone to compare prices more easily.

Consumers discriminate better on price, Consumers discriminate better on price, and firms become more competitive. Both and firms become more competitive. Both factors are anti-inflationary.factors are anti-inflationary.

Foreign ReservesForeign Reserves Member countries do not have to hold Member countries do not have to hold

reserves of other member countries’ reserves of other member countries’ currencies.currencies.

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Benefits (3)Benefits (3) If the monetary union is a large, successful, If the monetary union is a large, successful,

and stable economic entity, then its and stable economic entity, then its currency is likely to become an international currency is likely to become an international medium of exchange—a dominant currency.medium of exchange—a dominant currency.

This makes it easier and cheaper for the This makes it easier and cheaper for the union to sell its debt in foreign markets. union to sell its debt in foreign markets.

Foreign banks will hold its currency in Foreign banks will hold its currency in reserve.reserve.

The union may also contribute to price The union may also contribute to price stability for its members, encouraging long-stability for its members, encouraging long-term commitment of resources by the term commitment of resources by the public, and providing clearer economic public, and providing clearer economic signals to market participants.signals to market participants.

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Is the EU an OCA?Is the EU an OCA?

An OCA, according to theory:An OCA, according to theory: Must consist of only economically Must consist of only economically

integrated countries. This ensures that integrated countries. This ensures that shocks are symmetric.shocks are symmetric.

Economic integration leads to the Economic integration leads to the formation of a flexible common market formation of a flexible common market for all factors of production and for all factors of production and products—another requirement. products—another requirement.

The central authority of the monetary The central authority of the monetary union must have significant fiscal union must have significant fiscal powers to be able to deal with powers to be able to deal with remaining asymmetric shocks.remaining asymmetric shocks.

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Is the EU an OCA? (2)Is the EU an OCA? (2)

The The Single European Act (SEA)Single European Act (SEA) which which became effective in 1993 contributed to became effective in 1993 contributed to the integration of many aspects of the EU the integration of many aspects of the EU countries.countries. The idea was to create a The idea was to create a Single European Single European

Market (SEM)Market (SEM) without frontiers or barriers. without frontiers or barriers. Differences still exist in:Differences still exist in:

The legal, taxation, and financial systems.The legal, taxation, and financial systems. The organization and flexibility of labor The organization and flexibility of labor

markets,markets, Economic growth rates, and Economic growth rates, and Unemployment rates.Unemployment rates.

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Is the EU an OCA? (3)Is the EU an OCA? (3)

(EU, EU15, EU25)(EU, EU15, EU25) Biggest differences are between the Biggest differences are between the

Northern and Central European countries Northern and Central European countries and the Southern Mediterranean countries.and the Southern Mediterranean countries.

The northern/central region includes the The northern/central region includes the more developed industrial countries, while more developed industrial countries, while the southern region includes more the southern region includes more agriculture-based employment.agriculture-based employment.

This became an issue again with the May This became an issue again with the May 2004 expansion to the EU to include 10 2004 expansion to the EU to include 10 new member countries. new member countries.

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Is the EU an OCA? (4)Is the EU an OCA? (4) Bayoumi and Eichengreen (1994) estimated Bayoumi and Eichengreen (1994) estimated

and compared permanent supply shocks among and compared permanent supply shocks among 8 U.S. regions and among 11 EU countries.8 U.S. regions and among 11 EU countries. Permanent supply shocks were not correlated across Permanent supply shocks were not correlated across

the EU countries, whereas the U.S. regional supply the EU countries, whereas the U.S. regional supply shocks were highly correlated.shocks were highly correlated.

Supply shocks in the EU were also larger than those in Supply shocks in the EU were also larger than those in the U.S. regions.the U.S. regions.

They concluded that the 11 EU countries did not They concluded that the 11 EU countries did not constitute an OCA. constitute an OCA.

They argued that a smaller core of EU countries They argued that a smaller core of EU countries comprised of Germany, France, Belgium, Netherlands, comprised of Germany, France, Belgium, Netherlands, and Denmark form a more homogeneous group, and and Denmark form a more homogeneous group, and therefore more qualify as an OCA.therefore more qualify as an OCA.

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Is the EU an OCA? (5)Is the EU an OCA? (5) These authors recommended that this core These authors recommended that this core

group form a monetary union, and that other group form a monetary union, and that other countries be added as they meet certain countries be added as they meet certain integration criteria.integration criteria.

A study by the EC Commission (1990) found that A study by the EC Commission (1990) found that some costs of forming a monetary union had some costs of forming a monetary union had been exaggerated, shifting the cost-benefit ratio been exaggerated, shifting the cost-benefit ratio in favor more inclusive membership.in favor more inclusive membership. The loss of exchange rate policy was not as critical as The loss of exchange rate policy was not as critical as

some had estimated previously.some had estimated previously. Exchange rate policies against one another tends to Exchange rate policies against one another tends to

allow one to gain at the expense of the other. As a allow one to gain at the expense of the other. As a result, such policies tend to be met with reprisals, thus result, such policies tend to be met with reprisals, thus reducing the benefits of such policy.reducing the benefits of such policy.

Also, such policies depend on prices being stable, so Also, such policies depend on prices being stable, so that real exchange rates actually change.that real exchange rates actually change.

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External Benefits of External Benefits of IntegrationIntegration

The joint/total reduction of transactions costs The joint/total reduction of transactions costs among member nations has been estimated among member nations has been estimated at about 1% of their joint GDP.at about 1% of their joint GDP.

Each country joining the EMU also generates Each country joining the EMU also generates external benefits.external benefits.

As more countries join, the benefits of As more countries join, the benefits of monetary integration also increase.monetary integration also increase.

One problem with applying this to the EMU is One problem with applying this to the EMU is that the EMU lacks substantial budget power.that the EMU lacks substantial budget power. This makes it impossible for the the central This makes it impossible for the the central

authority to compensate (through redistribution) authority to compensate (through redistribution) member countries for external benefits or member countries for external benefits or individual costs.individual costs.

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External Benefits of External Benefits of Integration (2)Integration (2)

It has become clear that the It has become clear that the countries that benefited most from countries that benefited most from the EMU are those that “imported the EMU are those that “imported price stability” by adopting the price stability” by adopting the common currency, avoiding local common currency, avoiding local political pressures to inflate their political pressures to inflate their currencies.currencies.

These are primarily Greece, Spain, These are primarily Greece, Spain, Portugal, Italy, and Ireland.Portugal, Italy, and Ireland.

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Labor Markets in the EULabor Markets in the EU Labor markets in Europe are rigid. Labor markets in Europe are rigid.

They have They have low mobilitylow mobility. Many European . Many European workers are unwilling to relocate to seek workers are unwilling to relocate to seek employment within their own country, let alone employment within their own country, let alone to other countries. This is attributed to:to other countries. This is attributed to:

Cultural barriersCultural barriers LanguageLanguage Climatic problemsClimatic problems

They have They have high wage rigidityhigh wage rigidity. EU labor markets . EU labor markets have strict labor laws and labor organizations have strict labor laws and labor organizations which are responsible for such wage rigidity.which are responsible for such wage rigidity.

Most economists are convinced that labor Most economists are convinced that labor market rigidity is one of the most important market rigidity is one of the most important causes of high unemployment rates in EU causes of high unemployment rates in EU countries.countries.

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Labor Markets in the EU (2)Labor Markets in the EU (2) One problem is the heavy centralization of One problem is the heavy centralization of

trade unions and employers associations trade unions and employers associations that often negotiate labor agreements at the that often negotiate labor agreements at the national or regional levels.national or regional levels. This allows for little variation of wages to account This allows for little variation of wages to account

for differences in labor productivity among for differences in labor productivity among companies.companies.

Small companies often cannot afford to pay such Small companies often cannot afford to pay such wages when their levels of automation and wages when their levels of automation and volumes do not permit the high productivity rates volumes do not permit the high productivity rates needed to support high wages.needed to support high wages.

Economic theory suggests that firms optimize Economic theory suggests that firms optimize when they pay labor its marginal product.when they pay labor its marginal product.

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Labor Markets in the EU (3)Labor Markets in the EU (3) Since the late 1990s, many policies were Since the late 1990s, many policies were

adopted in almost every EU state to introduce adopted in almost every EU state to introduce more flexibility with labor markets.more flexibility with labor markets.

Incentives were offered to firms to increase Incentives were offered to firms to increase hiring and to unemployed workers to seek jobs hiring and to unemployed workers to seek jobs more aggressively.more aggressively.

Employment levels have improved, but many of Employment levels have improved, but many of the gains have been through temporary, the gains have been through temporary, contract, and part-time employment.contract, and part-time employment.

From 1996 to 2001, employment in the Euro From 1996 to 2001, employment in the Euro Area increased by 1.6% per year. (U.S. Area increased by 1.6% per year. (U.S. employment increased by 1.3% per year, even employment increased by 1.3% per year, even though its economy grew more quickly.)though its economy grew more quickly.)

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A Success StoryA Success Story

Ireland was a slow-growth, low Ireland was a slow-growth, low income country not so long ago.income country not so long ago.

By 2001, Ireland had the 2By 2001, Ireland had the 2ndnd highest highest per capita income in the EU per capita income in the EU ($28,500). ($28,500).

Ireland also has the lowest Ireland also has the lowest corporate tax rate in the EU at corporate tax rate in the EU at 12.5%.12.5%.

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The Lisbon AgendaThe Lisbon Agenda During the March 2000 EU Summit in Lisbon, During the March 2000 EU Summit in Lisbon,

Portugal, the members agreed to transform Portugal, the members agreed to transform the EU by 2010 into the most dynamic, the EU by 2010 into the most dynamic, knowledge-based, competitive economy in knowledge-based, competitive economy in the world.the world.

The countries agreed to pursue economic, The countries agreed to pursue economic, social, and environmental policies that would social, and environmental policies that would lead to sustained development, high lead to sustained development, high economic growth, and social cohesion.economic growth, and social cohesion.

They will pursue structural reforms by They will pursue structural reforms by investing in R&D and innovation, and by investing in R&D and innovation, and by completing the SEM.completing the SEM.

The idea is to make the EU more of a OCA.The idea is to make the EU more of a OCA.

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The Lisbon Agenda (2)The Lisbon Agenda (2) Among the changes introduced in the individual Among the changes introduced in the individual

countries, have been the reforms called for by firms:countries, have been the reforms called for by firms: To reduce long-term unemployment benefits,To reduce long-term unemployment benefits, To Reduce pension payments,To Reduce pension payments, To have more freedom in laying off workers, andTo have more freedom in laying off workers, and To have more freedom in increasing working hours per To have more freedom in increasing working hours per

week.week. Not surprisingly, many EU workers and trade unions Not surprisingly, many EU workers and trade unions

saw these proposals as challenges to workers’ rights saw these proposals as challenges to workers’ rights and benefits, and an adoption of U.S. practices.and benefits, and an adoption of U.S. practices.

Many governments accepted in principle the Lisbon Many governments accepted in principle the Lisbon Agenda as a necessary program to help the EU Agenda as a necessary program to help the EU economist recover from slow growth and economist recover from slow growth and unemployment.unemployment.

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Example: FranceExample: France Nicholas Sarkozy, a French politician, asked Nicholas Sarkozy, a French politician, asked

Michel Camdessus, a former head of the Michel Camdessus, a former head of the IMF for an explanation of the causes of the IMF for an explanation of the causes of the French economic slowdown, and asked for French economic slowdown, and asked for recommendation to reinvigorate the French recommendation to reinvigorate the French economy.economy.

Camdessus with a 20-member team Camdessus with a 20-member team published a 140-page report in 2004.published a 140-page report in 2004. He argued that the problem was a failure to He argued that the problem was a failure to

respond to challenges related to:respond to challenges related to: The diffusion of new technologies and trainingThe diffusion of new technologies and training An aging populationAn aging population GlobalizationGlobalization

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Example: France (2)Example: France (2) Recommendations:Recommendations:

Liberalize the labor market,Liberalize the labor market, Reduce public debt, andReduce public debt, and Get the universities and companies to work Get the universities and companies to work

together to promote the necessary knowledge together to promote the necessary knowledge base among the workforce.base among the workforce.

He argued that similar reforms were working He argued that similar reforms were working in:in: Sweden (which restructured its labor markets and Sweden (which restructured its labor markets and

state pensions)state pensions) Finland (which attained a high-level knowledge Finland (which attained a high-level knowledge

economy)economy) Denmark (which reformed its welfare state)Denmark (which reformed its welfare state) UK (which liberalized its labor market)UK (which liberalized its labor market)

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Example: France (3)Example: France (3) Camdessus found that for many years GDP Camdessus found that for many years GDP

growth for the U.S. exceeded that of France growth for the U.S. exceeded that of France and other EU countries, and the U.S. and other EU countries, and the U.S. unemployment rates were lower.unemployment rates were lower.

At the same time, labor productivity in the At the same time, labor productivity in the U.S is about the same time as in France.U.S is about the same time as in France.

The direct implication is that the problem if The direct implication is that the problem if France and the EU in catching up to the France and the EU in catching up to the U.S. is not competitiveness of its industries. U.S. is not competitiveness of its industries.

European workers, by choice, work 20% European workers, by choice, work 20% fewer hours than U.S. workers. fewer hours than U.S. workers.

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Example: SwedenExample: Sweden

Introduced substantial labor market Introduced substantial labor market flexibility that has increased manufacturing flexibility that has increased manufacturing sector labor productivity.sector labor productivity. Unfortunately, Sweden did not increase labor Unfortunately, Sweden did not increase labor

productivity in the services sector as in the U.S.productivity in the services sector as in the U.S. Wages are no longer set at the national Wages are no longer set at the national

level. Sectoral labor contracts are flexible.level. Sectoral labor contracts are flexible. The pension system was reformed:The pension system was reformed:

Pension income is determined according to real Pension income is determined according to real wages, longevity of the retiree, and the growth wages, longevity of the retiree, and the growth of the economy. This ensures the integrity of the of the economy. This ensures the integrity of the system.system.

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The Future of the Lisbon The Future of the Lisbon AgendaAgenda

According to a 2004 EC Commission report, the According to a 2004 EC Commission report, the following areas are key to achieving the goals of the following areas are key to achieving the goals of the Lisbon Agenda:Lisbon Agenda:

Investment in networks and knowledge.Investment in networks and knowledge. Strengthening competitiveness in industry and services through Strengthening competitiveness in industry and services through

the completion of the internal market.the completion of the internal market. Increased labor participation of older people by encouraging Increased labor participation of older people by encouraging

older workers to delay retirement.older workers to delay retirement. After reviewing the Commission report, in March, 2004, After reviewing the Commission report, in March, 2004,

the EU leaders pledged to accelerate the pace of the the EU leaders pledged to accelerate the pace of the reforms. reforms.

The Dutch prime minister, Wim Kok, was chosen to The Dutch prime minister, Wim Kok, was chosen to head a group to study the progress. The Kok Report of head a group to study the progress. The Kok Report of November 2004 focused on the lack of political November 2004 focused on the lack of political commitment of the EU member states to the objectives.commitment of the EU member states to the objectives.

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Comparative Statistics, Comparative Statistics, 1999-20031999-2003

Euro Euro AreaArea

USUS JapanJapan

Real GDP Growth Real GDP Growth (%)(%)

1.781.78 2.722.72 1.221.22

Unemployment Rate Unemployment Rate (%)(%)

8.768.76 4.964.96 5.025.02

Inflation Rate (%)Inflation Rate (%) 1.941.94 2.462.46 -0.58-0.58

Area (thous. sq. Area (thous. sq. km.)km.)

2,5092,509 9,639,6311

377377

Population (millions)Population (millions) 308.7308.7 291.291.11

127.6127.6

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Euro TimelineEuro Timeline

1957:1957: The Treaty of Rome was signed, The Treaty of Rome was signed, establishing the EEC and EUROTOM.establishing the EEC and EUROTOM.

1958:1958: The Monetary Committee was The Monetary Committee was formed as an advisory body to the formed as an advisory body to the ECOFIN.ECOFIN.

1964:1964: The Committee of Central Bank The Committee of Central Bank Governors was formed.Governors was formed.

1970:1970: The Final report of the Werner The Final report of the Werner plan is completed. (Feasibility of a plan is completed. (Feasibility of a European Monetary System)European Monetary System)

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Euro Timeline (2)Euro Timeline (2) 1979:1979: The EMS became effective. The EMS The EMS became effective. The EMS

consisted of three components:consisted of three components: Exchange Rate Mechanism (ERM)Exchange Rate Mechanism (ERM) European Currency Unit (ECU)European Currency Unit (ECU) European Monetary Cooperation Fund (EMCF)European Monetary Cooperation Fund (EMCF)

1989:1989: The Delors Report is published. The Delors Report is published. (Recommends three stages for deployment (Recommends three stages for deployment of a full monetary union for the EC)of a full monetary union for the EC)

1991:1991: The Maastricht Treaty was approved The Maastricht Treaty was approved by the heads of the EC states in 1991, by the heads of the EC states in 1991, signed in Maastricht in 1992, and comes signed in Maastricht in 1992, and comes into force in 1993.into force in 1993.

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Euro Timeline (3)Euro Timeline (3)

1999:1999: The EMU is launched in 11 EU The EMU is launched in 11 EU countries.countries.

2002:2002: Euro notes and coins are Euro notes and coins are distributed in 12 European countries. distributed in 12 European countries. On March 1, 2002, the euro is the On March 1, 2002, the euro is the sole legal tender in 12 Euro Area sole legal tender in 12 Euro Area countries.countries.

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The EurosystemThe Eurosystem Monetary policy in the Euro Area is entrusted to Monetary policy in the Euro Area is entrusted to

the Eurosystem. This consists of:the Eurosystem. This consists of: The European Central Bank (ECB)The European Central Bank (ECB) 12 National Central Banks (NCBs)12 National Central Banks (NCBs)

The organization is remarkably similar to the U.S. The organization is remarkably similar to the U.S. Federal Reserve System, although the number of Federal Reserve System, although the number of NCBs is only coincidentially the same as the NCBs is only coincidentially the same as the district banks in the U.S. system.district banks in the U.S. system.

There will be an NCB for each country that joins.There will be an NCB for each country that joins. Along with the General Council, an advisory body Along with the General Council, an advisory body

to the ECB, and the NCBs of non-euro countries, to the ECB, and the NCBs of non-euro countries, this constitutes the European System of Central this constitutes the European System of Central Banks (ESCB).Banks (ESCB).

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European System of Central European System of Central BanksBanks

GOVERNING COUNCIL(Decision-making Body)

Executive BoardPresident 1Vice President 1Members 4

6

Governors of NCBs 12

Total 18

EUROPEAN CENTRAL BANK (ECB)Frankfort, Germany

Formulatesmonetary policy

NCB1 NCB2 NCB12

NCB13NCB24 NCB25…

…

National Central Banks implement monetary policy in the Euro Area

GENERAL COUNCIL(Advisory Body)

President 1Vice President 1Governors of NCBs of all countries 25

Total 27

National Central Banks that have not adopted the euro

EUROSYSTEM

advi

se

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EurosytemEurosytem

Note that the distinction between the Note that the distinction between the Eurosystem and the ECSB will Eurosystem and the ECSB will continue until all EU member continue until all EU member countries join the EMU and adopt the countries join the EMU and adopt the euro. euro.

At that time, the system will simply At that time, the system will simply be the ECSB.be the ECSB.

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The Governing CouncilThe Governing Council The Governing Council formulates the The Governing Council formulates the

monetary policy of the Euro Area.monetary policy of the Euro Area. The Maastricht Treaty requires the The Maastricht Treaty requires the

Governing Council to convene at least 10 Governing Council to convene at least 10 times per year, but it usually meets twice a times per year, but it usually meets twice a month in the Eurotower in Frankfurt, month in the Eurotower in Frankfurt, Germany.Germany.

It has three (3) major functions:It has three (3) major functions: Provide price stability,Provide price stability, Provide liquidity to the entire Euro Area Provide liquidity to the entire Euro Area

banking and financial system, andbanking and financial system, and Establish and maintain an efficient payments Establish and maintain an efficient payments

mechanism throughout the EU.mechanism throughout the EU.

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The Governing Council (2)The Governing Council (2) To do this, the Governing Council controls To do this, the Governing Council controls

bank reserves, sets certain key interest rates, bank reserves, sets certain key interest rates, and ultimately attempts to control the money and ultimately attempts to control the money supply in the Euro area.supply in the Euro area.

The first president was Willem Duisenberg, The first president was Willem Duisenberg, previous the governor of the Dutch Central previous the governor of the Dutch Central Bank.Bank.

The second president is Jean-Claude Trichet, The second president is Jean-Claude Trichet, previously president of the French Central previously president of the French Central Bank.Bank.

Both presidents are known for their strong Both presidents are known for their strong stance on price stability in their countries.stance on price stability in their countries.

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The Executive BoardThe Executive Board

Executive Board members serve 8-year, Executive Board members serve 8-year, nonrenewable, staggered appointments. It is nonrenewable, staggered appointments. It is hoped that this will provide continuity of hoped that this will provide continuity of experiences members on the Board.experiences members on the Board.

The Executive Board is responsible for The Executive Board is responsible for implementing monetary policy on a daily implementing monetary policy on a daily basis. The Executive Board instructs the basis. The Executive Board instructs the NCBs to conduct certain policies.NCBs to conduct certain policies. The idea is that the NCBs are closer to their local The idea is that the NCBs are closer to their local

money and financial markets, and therefore are money and financial markets, and therefore are better able to implement policy. Geographic better able to implement policy. Geographic distance was one reason given. (Like US FRBs?) distance was one reason given. (Like US FRBs?)

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The General CouncilThe General Council

To coordinate actions between euro To coordinate actions between euro and non-euro EU countries, the and non-euro EU countries, the General Council was created.General Council was created.

The General Council inherited the The General Council inherited the responsibilities of the previous responsibilities of the previous European Monetary Institute (EMI) European Monetary Institute (EMI) which was dissolved with the creation which was dissolved with the creation of the ECB.of the ECB.

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ObjectivesObjectives The primary objective of the ECB is the pursuit of The primary objective of the ECB is the pursuit of

price stability for the entire Euro Area, as stated in price stability for the entire Euro Area, as stated in Article 105 of the Treaty which established the EC.Article 105 of the Treaty which established the EC.

In order to do this, the ECB was granted political In order to do this, the ECB was granted political independence from other EU institutions and independence from other EU institutions and national governments. As of today, the ECB is national governments. As of today, the ECB is considered the most independent central bank in considered the most independent central bank in the world. (It was modeled after the Bundesbank the world. (It was modeled after the Bundesbank of Germany.of Germany.

It is prohibited from financing government deficits.It is prohibited from financing government deficits. It is institutionally and financially independent It is institutionally and financially independent

from EU institutions by having its own budget. (It is from EU institutions by having its own budget. (It is financed by the NCBs and not the EU budget.financed by the NCBs and not the EU budget.