Thesis

The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc.
Finance and International Business Stefan Zidaru
The European Central Bank: Monetary Policy Instruments, Crisis Management and European Macroeconomic Performance
Aarhus School of Business Author: Student number: Counselor: Department: Handed in: Stefan Zidaru 287884 Morten Balling Department of Business Studies 30/08/2010
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru
Table of Contents
1. Introduction.3 1.1 Problem statement................................................................................................3 1.2 Method...4 1.3 Delimitations..6 2. The European Central Bank and its monetary policy.....7 2.1 Introduction to the European Central Bank..7 2.2 The monetary policy of the ECB until the beginning of the financial crisis..13 3. The European banking system.....26 3.1The development of the European banking system until the beginning of the financial crisis28 3.2 The effect of the financial crisis on the European banking system.31 4. Empirical evidence of the usefulness of the monetary policy....36 5. Was the American way better? A brief comparison between the ECBs and the Feds monetary policies..48 6. Conclusions.61 7. Bibliography...63 8. Appendix 1......68 9. Appendix 2..70 10. Appendix 3....77
1. Introduction 1.1 Problem Statement

The banking system has always been the main pillar of every economy. But more importantly, central banks have never been more powerful as the monetary policy has long become the central tool of macroeconomic stabilization. Consequently, in these difficult financial times the central banks are more powerful than ever and since Europe is becoming centralized to a higher degree, the new created European Central Bank plays the most important part among all central banks in the area. However, the job of the European Central Bank has been difficult even from the very beginning, in January 1999 as it faced very instable economical situations. The most important problems, it had to face were the quadrupling of the oil prices as well as pronounced movements in the foreign exchange markets. It also had to deal with the period of uncertainty, brought by the terrorist attacks of 11 September 2001 and the consequent geopolitical tensions. Even so, the European Central Bank managed to keep a low inflation rate and maintain the long term indicators stably enough for the European Banks to be able to develop constantly. The volatility in the short term exchange rates has been kept at a quite low level. The way in which the Central European Bank has managed to do all this certainly deserves a closer look, and that this paper intends to do. Nevertheless, even if the European Central Bank is the one that decided the monetary policy for the euro zone and thus also decided the way in which the financial crisis has been, its monetary policy can only influence the price level of the euro zone as a whole and cannot affect inflation differentials across regions or cities. Moreover, the European Central Bank can only coordinate the operations as the transactions are carried out by the national central banks. The ECB does this by the European System of Central Banks (ESCB), the link between the ECB and the NCBs. This system also includes the national banks of the countries that are EU Members but have not yet adopted the euro. The ESCB has the purpose to supervise
that the entire decision making is centralized and also that the tasks the EC Treaty has assigned to the ESCB are performed jointly and consistently in line with the allocation of powers and the objective of the system1. As the crisis developed the banking system all over the world the ECB had to react in the appropriate manner in order to maintain its main objective, price stability. This was a very difficult task as the crash of several credit and investment institutions lead to a series of economical events that also affected the national economies as a whole and thus influenced the prices of goods and services in a negative manner. In the autumn of the year 2008 the ECB had to face one of the greatest challenges since its validation. The empirical and theoretical studies of this paper will try to reveal if the actions that were taken were effective or if the different measures taken by the Fed proved be more reliable in this situation. In conclusion the main purpose of this paper is to analyze and clarify the following: 1. What was the monetary policy of the ECB from 1999 until the beginning of the financial crisis? 2. How well was the ESCB system working? 3. What is the financial crisis? 4. What were its effects on the banking sector in the Euro zone? 5. How did the ECB react? 6. What are the results of the ECBs monetary policy (empirical study)? 7. How did the Fed react to the same crisis? 8. How does the future of central banking will look like in the Euro zone?
1.2 Method
The main purpose of this paper is to analyze the monetary policy of the ECB during the financial crisis, in the Euro zone. However, this does not mean that the analyses will show the relation between the ECB and each central bank from the EU zone or how the crisis affected each of these central banks. The paper will give an overview of the monetary policy of the ECB and how it helped the central and
The European Central bank, History, role and functions, ECB,Hanspeter K. Scheller, 2006
commercial banks of the Euro zone to overcome the crisis. The comparison with the Feds monetary policy is made because the European Union looks very much like the federal state that USA is. In addition, the ECB and the Fed have a lot in common concerning the size of the economies they are dealing with and also the way of communicating with the national/federal banks. However, the Fed has much more experience in dealing with financial crisis at a federal level. Therefore, the Feds monetary policy was slightly different also because of external factors like the existence of only commercial banks and no central ones that needed to be coordinated. Nevertheless, comparison between these two federal central banks seems appropriate, but the emphasis will be on the ECBs monetary policy and the Feds monetary policy will be only looked at briefly and from a comparison point of view. The differences between the two monetary policies will be however explained from more points of view as financial responsibilities, different coordination targets, etc. The analysis will be made in different steps such as: an introduction to the European Central Bank and its monetary policy before the crisis, description of the crisis, the effect of the financial crisis on the European banking system in the Euro zone (central and commercial) and a comparison with the situation in the USA. The first part of this paper will present the validation of ECB and its responsibilities, scope and monetary policy. The ESCB and the Eurosystem will also be explained with more details and specific references to its connection to the ECB. In addition, the monetary policy of the ECB before and after the crisis will be detailed, analyzed and compared to the one adopted by the Fed, in the same period of time, so that objective conclusions can be observed. In order to asses the effectiveness of the ECBs an empirical study using standard time series will show how the banking sector has been historically affected by the decisions of the ECB of monetary policy. Furthermore, the future changes in this sector can be determined by forecasting the previously mentioned linear relationships. Moreover, the impact of the crisis over the Euro zone banking system is analyzed both in the short term and in the long run. Therefore, the paper will firstly analyze how the activities and the profitability of the banking system were affected by the financial challenges. This is done by both a qualitative analysis as well as by application of the previously developed model for 5
historical relationship between the banking industry in the Euro zone and the ECB. Using forecasting methods, future development of the banking sector can be obtained.
1.3 Delimitations
For performing the necessary analysis certain delimitations have to be made. All of the institutions mentioned in this paper have a very complex activity and the facts mentioned about them are most of the time the ones that concern the problem in question. Moreover, the monetary policy of the ECB, its mechanisms could be described in a more detailed manner, but that would prove inefficient as this paper is more about the consequences of the ECBs decision than the ECB itself. Therefore, the explanations are to give an overall image of the situation and not contain every fact as this would lead to further discussions. The facts that are not detailed in this paper can also be researched in other papers, articles or books that have made some specific problems part of their scope. The paper is also very concerned with the economical situations from 1999 until 30th March 2010 as this is the period of time that the ECB started to take decisions and the data was disclosed to the public. Moreover, the analysis is based on economical data from the euro zone countries that the ECB can really influence. Even so, the paper will take into consideration the external global factors as much as possible, but the special focus will be on the euro zone.
2. The European Central Bank and its monetary policy

This chapter will explain the birth of the European Central Bank, its monetary policy, but also the begging of the European system of central banks and the Eurosystem. The first part of this chapter focuses on the history of the European Central Bank, its purpose, its goals and the methods to achieve them. Moreover this part reveals the way in which the European Central Bank is organized, the different responsibilities of its president and board members, who are accountable to different superior control bodies to which they have to give detailed explanations concerning the decisions taken. The second part of this chapter deals with the monetary policy of the European Central Bank from the beginning of this institution until the beginning of the financial crisis (September 2008). This part of the chapter will briefly present the consequences of the monetary policy during the above mentioned period of time, but giving special attention to the most important events that took place and how they influenced the modification of the monetary policy.
2.1 Introduction to the European Central Bank

In order for the European Central Bank and the European Monetary union to be founded, a series of steps were necessary to be taken beginning as early as 1952. The first treaty that lead the way to the foundation of the European Union was the European Coal and Steel Community signed by Belgium, Germany, France, Italy, Luxembourg and Netherlands. The same six countries later on established the European Economic Community ECC and the European Atomic Energy Community in 1958. This community was joined in 1973 by three more countries, Denmark, Ireland and United Kingdom. Eight years later Greece also joined in, followed by Spain and Portugal in 1986.2 In 1986 The Single European Act was adopted by the member states at that time and six years later in 1992 The Treaty of the European Union was signed at Maastricht, establishing the three pillar structure (The European Communities, The Common
The European Central bank, History, role and functions, ECB, Hanspeter K. Scheller, 2006
Foreign and Security Policy, and The Justice and Home Affairs/ Police and Judicial Cooperation in Criminal Matters).3 The first steps towards monetary policy coordination were taken as the European Monetary institute was established on the 1st of January 1994. After this, the European Central Bank finally came into order on the 1st of June 1998, as the third and final stage of the European Monetary Union began. Therefore, by taking this final step, the member states agreed on the irrevocable fixing of conversion rates, the introduction of the Euro, the conduct of the single monetary policy by the European System of Central Banks, the entry in effect of the ERM II and also entry into force of the Stability and Growth Pact. As mentioned above, the European Central Bank began its activity on the 1st of June 1998 as part of the third stage plan of the EMU agenda. The main purpose of the ECB was and still is price stability. By achieving this goal, the member states wanted to encourage job creation and a more stable and consequently better developing economy. Moreover, in order to meet this objective the ECB has defined the price stability as a year-to-year increase in the Harmonized Index of Consumer Price (HICP) for the euro area of below 2%.4, and also that the ECB aims at maintaining inflation rates below, but close to 2% over the medium term5. The ECB had to make this statement as the Treaty does not specifically mention what price stability actually means. The ECB has therefore chosen a quantity definition of this term in order to be able to make a real comparison between different periods of time and to be able to give the public and the responsible authorities that they have to report to some real figures that can be measured very easily. In addition, the Treaty of Maastricht also defines the main tasks that have to be carried out by the ECB as: the definition and implementation of the monetary policy of the Community, the conduct of foreign exchange operations, the holding and managing of the official foreign reserves of the Members States and the promotion of the smoothing of the operation of payment systems, the issuing of banknotes and coins and
www.ecb.int/ecb/history/emu/html/index.en.html The ECBs monetary policy strategy, www.ecb.int/mopo/intro/html/index.en.html 5 ibid

4
also the collection of statistical information necessary for the tasks of the Eurosystem
6
. The ability of the ECB to formulate and implement the monetary policy of the
euro area is given by the control it has over the monetary base. This kind of control is ensured by article 106 of the Treaty that states that the ECB and the National Central Banks are the only institutions entitled to issue legal tender banknotes and coins. Having these rights, the ECB is sure to have the main influence over the money market and the money market interest rates. The foreign exchange operations are one of main factors that might disturb the domestic liquidity conditions and the exchange rates which are two of the most important variable for managing the monetary policy. These variables have to comply with the framework which the Treaty of Maastricht has established for the exchange rate policy of the euro area. However, in this matter, the ECB shares the responsibility with the European Union Council, which is actually the ultimate decision maker7. Nevertheless, the ECB has, as mentioned above, the responsibility of managing the official foreign reserves of the euro area. This also completes the ECBs function of conducting the foreign exchange operations. The ECB can additionally control the use of the National Central Banks foreign exchange holdings as well as Member States residual balances in foreign currencies. Last but not least, the task of promoting the smooth operation of payment system consolidates the idea of how important efficient systems are not only for the purpose of conducting monetary policies but also for the whole economy. However, other tasks of the ECB imply that this institution has to advise the appropriate Community institutions and bodies and national authorities in its fields of competences as stated in the article 105(4) of the EC Treaty and Article 4 of the Statute. In addition to this, the ECB can still perform those functions of the EMI which still need to be performed because of the EU Member States that have not yet adopted the Euro as their currency. From a legal point of view, article 107(2) of the EC Treaty
6 7
Treaty of Maastricht, article 105. The European Central bank, History, role and functions, ECB, Hanspeter K. Scheller, 2006
confirms the fact that the ECB has the most extensive legal capacity given to legal persons under the respective national law of each Member State. Consequently, it may acquire and dispose of movable and immovable property and also be a party to different legal proceedings. Moreover, the ECB has the necessary immunities to perform its specific tasks. However, as a legal person under international law, the ECB has to conclude international agreements in matters relating to its field of competences and also take part in the work of international organizations such as the International Monetary Fund, The Bank for International Settlements and the Organization for economic Co-operation and Development. Even if the ECB is takes actions under the EC Treaty, it is not defined as an institution in the proper meaning of the term. The ECB has three major decision making bodies: the Executive Board, the Governing Council and the General Council.
THE THREE MAIN DECISION MAKING BODIES OF THE ECB
EXECUTIVE BOARD
GOVERNING COUNCIL
GENERAL COUNCIL
PRESIDENT VICE-PRESIDENT
FOUR OTHER MEMBERS OF THE EXECUTIVE BOARD
FOUR OTHER MEMBERS OF THE EXECUTIVE BOARD
GOVERNORS OF THE EURO AREA NATIONAL CENTRAL BANKS
GOVERNORS OF THE NATIONAL CENTRAL BANKS OF ALL EU MEMBERS STATES
Chart 1
10
The Executive Board of the ECB formed of the President, the Vice-President and four other members which are all appointed by the Heads of State or Governments of the euro area countries8. According to the Statute of the ECB, the Executive Board is in charge of: a) preparing the meetings of the Governing Council b) implementing monetary policies in accordance with the guidelines and decisions presented by the Governing Council and also giving the necessary instructions to the euro area National central Banks c) being responsible for the current business of the ECB d) assuming certain powers delegated to it by the Governing Council, which may include powers of a regulatory nature. The Governing Council of the ECB is formed from six members of the Executive Board and also the sixteen governors of the National Central Banks of the euro area. Both the Governing Council and the Executive board are chaired by the President of the ECB. The Governing Council has two major responsibilities: adoption of the guidelines and taking of the decisions necessary to ensure the performance of the tasks entrusted to the Eurosystem; the formulation of the monetary policy of the euro area. The Governing Council also establishes all the necessary guidelines for the implementation of the decisions on intermediate monetary objectives, key interest rates and the supply of money reserves. The General Council of the ECB is composed of the President and VicePresident of the ECB and the governors of the twenty seven governors of the National Central Banks of all EU Member States. This council will exist as long as there are member states of the EU that have not adopted the euro as their currency. Even though the Council has no responsibility regarding the monetary policy but it still coordinates the Member States that have not adopted the euro currency to try to accede to the Euro zone monetary policy.
11
Moreover, the Council deals with the collection of the statistical information and the reporting activities of the ECB but also with the necessary preparation for the irrevocable fixing of the exchange rates of Member States that have not yet adopted the euro. A very important characteristic of the ECB is its independence from any political powers. Article 108 of the Treaty explicitly states that neither the ECB the National Central Banks, nor any other member of their decision making bodies are allowed to take any instructions from Community institutions or any other bodies. The governments of the Member states must also respect this principle and not try to influence any of the decision making parties of the ECB. In order to encourage the independence of the ECB, the ECBs financial arrangements are kept separate from those of the European Community. Therefore, the ECB has its own budget, and its capital is subscribed and paid up by the euro area National Central Banks. There is also the rule that reduces the incentive of potential political influence, which mentions that the members of the Executive Board cannot be re-appointed. The ECB is nonetheless very committed towards having a positive communication attitude in relation to the public and therefore gives a high priority to transparency. This is due to the fact that the ECB wants to make its policy more credible and effective and has decided to achieve this by making the public understand its decisions. Article 15 of the Treaty ensures that ECB is accountable for its actions in front of democratic institutions and the general public. According to this article the ECB has to publish quarterly reports and also weekly financial statements. Moreover it has to present an annual report about its activities and the monetary policy of the previous year to the European Parliament, the EU Council, the European Commissions and the European Council. In addition, corporate governance is formed by different levels of external and internal audit. External audit is formed of external auditors and European Court Auditors whereas the internal audit has a more complex structure. So, the internal audit body is formed of the Directorate Internal Audit under the direct supervision of the Executive Board, an internal control structure that is based on 12
the fact that each organizational unit is responsible of its own internal control and efficiency, a Code of Conduct and insider trading rules that gives guidance to the ECB staff and the Executive Board members, a compliance procedure and Ethics Adviser that deals with access of the employees to inside information, a Budgetary authority that is vested in the Governing Council and establishes the ECB budget, and a data protection officer. The ECB capital is given by the National Banks of all Member States. The share of each country is calculated with the help of a key that shows the countrys share in total population and gross domestic product of the EU9. These weights are adjusted every five years or whenever a new country joins the EU. The important difference that needs to be mentioned between the banks from euro area and those that are not from the euro area is that the latter are not entitled to any profit but are also not liable for any loses of the ECB. However, the profit the ECB makes is divided as stated in the article 33 of the ECB statute and the amount that is decided by the Governing Council (which cannot exceed 20% of the net profit) will be transferred to the general reserve fund. Then, the remaining profit shall be distributed to the shareholders according to the proportions of the paid-up shares. In the case the ECB suffers loses they will be first paid from the general reserve fund.
2.2 The monetary policy of the ECB until the beginning of the financial crisis
The best way to understand the monetary policy of the European Central Bank before the beginning of the financial crisis is to start by explaining the objective of this monetary policy. The main objective of the ECB, hence of its monetary policy is to ensure price stability. Because monetary policy can affect the real activity on the short run, the ECB is deemed to avoid creating fluctuations in the output and employment when it pursuits its objective. So, by influencing the conditions in the money market (short term interest
See annex 1
13
rate), the ECB makes sure that price stability is maintained over the medium term by the effects of the monetary policy transmissions mechanisms. This kind of consistency helps the ECB keep the inflation expectations rate at a constant level and gain more credibility. However, due to lags in the process of transmission mechanism the monetary modifications made at the present time will affect the price levels after a number of months or even a year. Therefore, the ECB must make its decisions of influence over the inflation rate by forecasting the future economical conditions and that is why its policy must be forward looking. Consequently there are some unanticipated shocks to the price level that give way to unavoidable volatility in the inflation rate. In addition, the decision of mechanisms transmission must take into consideration all aspects of the macroeconomic level and that is why its complexity makes it gain a certain element of uncertainty. Because of this, the ECB is trying to make all its decisions by taking into account the medium period of time and avoids excessive activism and the presence of unnecessary volatility into the economy10. Nonetheless, the ECB is also faced with the uncertainty of the reliability of the economical indicators, the structure of the euro area and the transmission mechanism of the single monetary policy. That is why its monetary policy must not rely on a single economical model and take into account all the possible factors that could have an impact and change in any way the economical indicators. The basic mechanism of monetary policy that the ECB uses is the modification of the short term interest rate. Even if for a short period of time this factor has an influence on output, unemployment, inflation, etc. in the long run, the only real impact is on prices. A modification in the quantity of money in circulation basically represents a change in the unit of account and has no real consequence on other variables different than prices (it is as if changing the measuring unit for weight and switching from grams to kilograms, that does not change the real weight). Moreover, the principle known as the long-run neutrality of money is present here and reveals its consequences. The employment level, the real income are thus
10
14
determined by real supply factors such as technology, population growth, tax policies, welfare policies, etc. Consequently, the ECB, as any other central bank, cannot change the economic growth by changing the money supply11. This proves that inflation is nothing more than a monetary phenomenon and can be controlled on the medium and long run by the central banks. The objective of price stability is one adopted by many central banks because it has proven to bring a certain number of economical benefits. Price stability implies avoiding prolonging a period of both inflation and deflation. The biggest impact it has on the economy is that it brings more transparency and allows the economical agents to recognize if the modification in prices is relative or not. This is a very important feature as investors and households can allocate the resources better. This also reduces the overall costs of economical price fluctuation because the general public is able to asses whether or not the modifications are due to a modification of monetary policy or real medications that happen due to other supply factors such as better work productivity. Moreover, the creditor agents can reduce or even stop demanding an inflation risk premium and therefore reduce the costs of borrowing money. This also leads to a more efficient allocation of resources and increases the incentive to invest and develop. The credibility stable prices bring is also another reason for the investors to avoid using hedging activities that would make investments more costly. This also encourages economical growth as goods are no longer stockpiled for inflation reasons and thus the resources are better used. Another important contribution that price stability has to the economical growth is that it eliminates the real costs entailed when inflation exacerbates the distortionary impact of taxes and social security systems12. Inflation can act as a tax by itself as it increases the cost of holding cash and therefore generates higher transaction costs. In addition, price stability has an important contribution to social and political stability as it prevents the arbitrary distribution of wealth and income. This might happen in an period of high inflation volatility as price change in an unpredictable ways
11 12
The monetary policy of the ECB, ECB 2004 page 41-42 The monetary policy of the ECB, ECB 2004 page43
15
and its usually the weakest groups of the society that suffer the most from this as their hedging possibilities are limited. All the arguments mentioned above support the idea that price stability plays a very important role to economical growth and development and it is a goal that is worth pursuing, as it leads to higher standards of living, higher levels of economic activity and better employment prospects. 13 In order for the ECB to meet its objective it needs a very good system to asses the economical situation and to respond adequately to the demands of the monetary market. That is why the ECB is using a two pillar framework that is based on economical and monetary analysis. These two perspectives are complementary as the former aims at assessing the short to medium-term determinants of price modifications focusing on the real activity and the financial economical conditions, as the later focuses more on the long term perspective emphasizing the connection between the link between money and prices14 . The two pillar approach is meant to make sure that no important piece of information is overlooked and that the two approaches also cross-check each other. Therefore, this diversified approach reduces the risk of policy error occurrence caused by over-reliance on a single indicator, forecast or model15. The economic analysis focuses on dealing with financial variables such as: developments in overall output, aggregate demand and its components, fiscal policy, capital and labour market conditions, a broad range of price and indicators, developments in the exchange rate, the global economy and the balance of payments, financial markets and last but not least, the balance sheet positions of the euro area sectors16. These variables are taken into consideration in order to correctly asses the dynamics of the real activity and the likely modifications of prices from the perspective of the interaction between the supply and demand of goods, services and factor markets at shorter horizons.
ibid ibid 15 The European Central bank, History, role and functions, ECB, Hanspeter K. Scheller, 2006, page 83
14 16
13
The monetary policy of the ECB, ECB 2004 page 54-56
16
Furthermore, this analysis focuses more on the identification of the nature of the shocks that hit the economy, their effects on costs and pricing behavior and the short to medium term of their propagation in the economy17. This identification is a very important one as it dramatically influences the decisions of the Governing Council in regards to the actions that it takes to different kind of economical shocks. For example, the decision making body responses differently to inflationary consequences of a temporary rise in the international price of oil than to higher prices deriving from wage increases not in line with productivity growth. In this example the latter has more important consequences as there is a high probability of entering a selfsustaining spiral of higher costs and therefore affect the economy on the long run. The Governing Council makes its decisions based on the facts presented by the economic analysis, the monetary analysis, individual indicators and forecasts of other institutions. That is why the economical analysis is important, but it is neither the only nor the most important factor in decision making activities. The monetary analysis is meant to bring in the overall analysis the medium and long term perspective on which the ECB relies on for making the medium term monetary policy strategy. This kind of perspective restrains the ECB from being to much involved and intervene too much on the short term condition. For a better assessment of the monetary policy, the ECB has decided to announce a reference value for the monetary aggregate M3. This benchmark of the growth of M3 is deemed to keep the ECB aware of its price stability objective on the medium term and not to have an immediate reaction at any deviation of the M3 growth from this reference value. One reason for this is that some monetary modifications might occur on the account of special factors like the modifications of tax treatments of interest income or capital gains18. These kinds of modifications may not be too precise about the general outlook of the price stability. Furthermore, the monetary analysis takes into consideration even more liquid components of the M3, such as the M1, in order to clarify the exact signal the monetary developments are sending.
17 18
ibid ibid
17
The ECB considers the two pillar approach very important as it makes it aware of its medium term objective while taking into consideration the short and long term factors that influence price stability. The two different approaches not only complement each other but also give the appropriate framework for making the best possible monetary decisions. As the Governing Council is the main decision body responsible for the monetary policy strategy, the way it chooses to influence the price level is crucial. Moreover, the way the monetary policy decisions affect the economy in general and the price levels in particular is called transmission mechanism of monetary policy. The macro economical view of the economy helps to better understand the way in which different monetary policy decisions affect different economical indexes on the short term and eventually price levels on the medium and long term. The first link in this complex net of interdependent variables is the change in the official interest rate set by the ECB on its own operations. These kinds of operations provide the liquidity for commercial banks that they need, in order to meet the public demand for money. Due to its monopoly over the creation of base money, the ECB, as any other central bank, can fully influence the interest rate on its operations. This has an impact on the money market interest rates, as the commercial banks have to include these modifications in interest rate in their activities with the general public (loans and deposits). The consequence of such decisions leads to further modifications of the other financial variables such as asset prices and exchange rates that in turn influence the investment decisions of households and investors. This leads to more consequences over the level of loans and deposits as high interest rate give a more reason to savings than credits, which also affect the level of demand of goods and services in the general economy. Thus, this leads to a change in the conditions of different markets, such as labor and intermediate products and it can even lead to changes in the wages level or price setting in the respective market19. Other modifications suffered by the changes in the monetary market are those of the exchange rates.
19
The monetary policy of the ECB, ECB 2004 page 46
18
This leads to even more modifications of the inflation rate. The appreciation of the exchange rates has a decreasing affect on the price of imported goods and, as a direct consequence this reduces inflation as products are directly used in consumption. However, if the imported goods and services are used as inputs on the production process, the same process takes place but in a longer period of time. In addition, the change in exchange rates might also have an impact on the way domestic goods are regarded on the international market, as an appreciation of the exchange rates leads to making the domestic products to be less competitive. Therefore, in ceteris paribus conditions, the appreciation of the exchange rates leads to a reduction in the inflationary pressure. Another important transmission channel of the monetary policy that the ECB can use is the private sectors long term inflation expectation. This of course depends a lot on the degree of credibility of the ECB on pursuing the stated objectives. If the ECB is seen as a very credible and reliable institution then the monetary policy has a very high impact on the development of prices by guiding the economic agents expectations of future inflation and thereby influencing their wage and price setting behaviour20. Nevertheless, the long lags between the monetary policy decisions and their real impact on the economical indicators have to be taken into consideration. As mentioned earlier in this chapter, between the moment from which a monetary decision policy is taken and the moment it starts to influence the economy there are certain important time lags that can vary from some months to even a year. Thus, the monetary policies decision bodies have to take into consideration further developments of the economy and include such estimation in the economical models they use. Even so, there are still some other uncertain actors such as exogenous shocks that come from very different and unpredictable sources like the change in oil price, the development of the world economy, etc.
20
ibid
19
OFFICIAL INTEREST RATES EXAMPELS OF SHOCKS OUTSIDE THE CONTROL OF THE CENTRAL BANK
EXPECTATIONS
BANK AND MARKET INTEREST RATES
MONEY CREDIT
ASSET PRICES
EXCHANGE RATES
CHANGES IN GLOBAL ECONOMY
WAGE AND PRICE-SETTING
SUPPLY AND DEMAND IN GOODS AND LABOUR MARKETS
CHANGES IN FISCAL POLICY
DOMESTIC PRICES
IMPORT PRICES
CHANGES IN COMODITY PRICES
PRICE DEVELOPMENTS
Chart 221
As stated previously, the ECB uses the short term interest rate as the main tool for adjusting the monetary policy for meeting its main objective of price stability. But the way the ECB achieves this disserves taking a closer look. To begin with, the ECB is the sole issuer of currency in the euro area, but besides this it also controls the reserves the central banks are bound to hold at it. This can only emphasize the fact that the ECB manages the liquidity situation in the money market. Moreover, the ECB can also change the conditions of the transactions it has with the credit institutions and bring further modifications to the monetary policy. Therefore, the ECB uses three main instruments to control the monetary policy: open market operations, standing facilities and minimum reserves. The open market operations can be further divided into four main categories such as: main refinancing operations, longer term operations, fine tuning operations and
The monetary policy of the ECB, ECB 2004 page 45, A stylized illustration of the transmission mechanism from interest rates to prices
21
20
structural operations. The main refinancing operations are basically loans that the ECB gives to other banks but only under certain conditions formulated in the Eurosystems monetary policy framework. The longer term refinancing operations have the same characteristics as the main refinancing operations, the only difference being that they have a longer maturity and a lower frequency. Fine tuning operations are made with the purpose of smoothing the effects on interest rate of unexpected liquidity fluctuations in the money market. Therefore they are executed in a very short period of time (it takes about an hour from the announcement to the communication of the allotment results). Structural operations are only used to adjust the structural liquidity position of the Eurosystem. They can also be conducted by using reverse transactions, outright operations or the issuing of debt certificates. Standing facilities are overnight loans and deposits that the ECB offers at disadvantageous interest rates comparing to the market rate. There is also the condition of limiting these kind of offers to the amount of collateral available, thus providing a ceiling for the overnight rate. However, because of these main reasons, the banks are not encouraged to use these facilities that often but mainly as a last resort measure or exceptional circumstances22. As any other central bank the ECB requires the other credit institutions to hold compulsory deposits that are called minimum or required reserves. The way in which the ECB determines the amount each credit institution has to have as a minimum reserve is by first determining a reserve base, starting from the institutions balance sheet elements. Furthermore, the reserve base is multiplied by a reserve ratio. However, the institutions have the option to deduct a lump-sum from their reserve requirements as the ECB did not want to have to high administrative costs for small amounts of money23. Briefly speaking, the reserve requirements are the difference between the multiplication of reserve base and reserve ratio and the lump-sum allowance.
22 23
See annex 2 for further details The monetary policy of the ECB, ECB 2004 page 77
21
Nevertheless, the ECB wants to avoid putting a burden on the banking system and consequently decided to make the holdings these institutions have to keep pay off. The interest rate is close to the market one for short term operations.
ECB INTEREST RATES

7 6 rate 5 %
fiexd rates
4 3
variable rates
2 1 0
interest rate on the m arginal lending facility interest rate on the deposit facility
in time from medium values to very low ones that are now shown in the present. The transition period towards an integrated euro area money market was handled by the Governing Council in the way that the corridor of interest rates was very much reduced. This can be easily observed by looking at the evolution of the values of the interest rates between the 1 and 4 and January. Therefore, the difference between interest rates or deposits, lending facilities and fixed interest rates for main refinancing operations was a small one of no more than 25 base points for each facility24. By this monetary policy, the Governing Council
ECB Press conference: Introductory statement Willem F. Duisenberg, President of the European Central Bank, Thursday, 7 January 1999
24
1J 22 an-J 99 a 5- n-9 N 17 ov- 9 -M 99 9- ar-0 Ju 0 1- n-0 11 Sep 0 -M -0 18 ay- 0 -S 01 6- ep-0 De 1 6- c-0 Ju 2 8- n-0 M 3 9- ar-0 A 13 ug 6 -D -06 13 ec-J 06 u 8- n-0 O 7 15 ct- 0 10 Oct- 8 -D 0 11 ec- 8 -M 0 13 ar 8 -M -09 ay -0 9
date
Chart 3 As shown in the above chart the interest rates ECB offers have been fluctuating 22
managed to make the credit institutions to have a large recourse towards the ECBs offered facilities. This situation was not to be prolonged for more than two weeks as it would otherwise hinder the economical development of the 11 euro area countries. As mentioned before, this was a measure that was just meant to make the transition to a new market system easier. Moreover, at the same, the new TARGET system began its activity as the new system for settlement of central bank operations, large-value euro interbank transfers as well as other euro payments. Basically, this is a payment system in which processing and settlement take place continuously more than in batch processing mode25. The lowest point in the values of interest rates between 1999 and 2003 was achieved on the 8th of April 1999 when the Governing decision decided to lower the interest rates even more from the previous periods. This decision was motivated to have been taken due to the reported ECB declining in the level of the M3 monetary aggregate. In addition to this, the Harmonized Index of Consumer Prices (HICP) rates of increase for the euro area had been below 1% for several months. Moreover, the demand for overnight loans was also decreasing and this was a clear sign that appropriate measures had to be taken. Because of the decrease in value for all interest rates, the ECB managed to achieve an increase in the value of the above mentioned monetary aggregate and in the loan demand. In addition, the Governing Council of the ECB decided on the 8th of June to modify the tender lending rate from a fixed one to a variable rate. This was explained by the Vice-President of the ECB, Mr. Christian Nover, to be a decision that complied with the markets evolution. Mr. Nover also argued that this decision was taken due to severe overbidding26. The variable rate was meant to adapt more easily to the high demands in liquidity and also respond more quickly to the developing market requests. Nevertheless, the highest values in interest rates were registered in October 2000 when the Governing Council decided to raise the already high rates.
25 26
ECB website, http://www.ecb.int/paym/t2/html/index.en.html ECB website, http://www.ecb.int/press/pressconf/2000/html/is000608.en.html
23
Consequently, the minimum bid rate for the main refinancing operations was raised to 4.75%, the interest rate for marginal lending facilities was raised to 5.75% and the interest rate for deposits was raised to 3.75%. The Governing Council of the ECB supported this decision by arguing that the monetary aggregate M3 had declined again to a value of 5.3%. Another important factor was the oil price that reached new peaks in September but when it decreased, the energy providing companies pushed the price even further on up words, thus putting even more pressure on the HICP inflation rates. Because this also caused a major distress in the foreign exchange markets and consequently influenced the price of the euro currency and also had a major impact on the HICP, the ECB together with the ministers of finance of the G7 countries decided to intervene in the foreign markets in order to keep the HICP and the fluctuation of their own currencies within reasonable normal limits of modifications. After this, due to the changes in the world economy, the ECB considered necessary to continue to lower the interest rates. This decision was also taken as the economic growth of the euro area diminished, being influenced by different factors or eternal geopolitical events such as the attacks of 9/11/2001, the Iraq crisis, the SARS virus, etc. This diminishing of interest rates had a climax or that period of time in June 2003 when the interest rates registered record low levels in their values. Therefore, the ECB had to explain this decision of continuously reducing the interest rates by the development of different world crisis that had an external impact on the euro zone economical growth. However, from a monetary analysis point of view the ECBs Governing Council agreed that the monetary aggregate M3 was consistently growing which led to the conclusion that economy had enough liquidity to sustain over the non-inflationary growth. Over the next five years, the ECB has raised the interest rates in accordance with the economical situations that occurred. The decisions taken during that period were always presented as being in perfect correlation with the institutions objective of keeping the HICP at a level of below but close to 2% and to thus maintain price stability. 24
However, it was not until October 2008 that the Governing Council of the ECB decided to start lowering the interest rates as the world economy started to enter a period of financial distress. The Governing Council announced by its voice, Mr. JeanClaude Trichet, the president of the ECB, that the future period of time was to be a very highly uncertain one. Unfortunately, the predictions were right and thus the ECB considered that it is better to lower the interest rates to new record historical low values. Moreover, the values have been so low that for the last four months (June, July, August and September) the inflation rates have been negative for the first time in the history of the ECB. But the details regarding the period of time after October 2008 will be given more attention in the next chapter. Another important matter of the ECB monetary policy was that the Governing Council also decided in October 2008 to use fixed interest rates for the main lending facilities. This decision was taken as soon as the new system of operating and processing information from the National Central Bank started to operate. The new system was called TARGET 2 and was meant to make the transactions between the ECB and the other credit institutions easier. Because the ECB could now rely on this new system, the Governor Council reached the conclusion that the interest rate for main financing operations needed to be changed and thus it started using a fixed interest rate for these kinds of operations. Since then, the ECB has only used a fixed interest rate for the main refinancing operations which it has continually lowered over the last year to a record level of 1%. The Governing Council has always explained the decisions by the help of its president, Mr. Jean-Claude Trichet declaring that it is completely related to the ECBs main objective of keeping the HICP at a rate lower, but close than 2% over a medium term.
25
Chapter 3. The European banking system

The best way to evaluate the situation of the European Banking system is to analyze it through the perspective of the economical indicators such as Euribor and Eonia, volume of credits given by the banks, number of banks, etc. Euribor is the interbank reference rate for 1, 2, 3 weeks and 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12 months that reflects the interest rates of the prime banks from the European Monetary Union. The Euribor rates are published each working day at 11:00 AM (CET) by the Thompson-Thompson Reuters service company. It is quite an interesting fact that the most used Euribor rate is the one for 12 months, mostly used for calculating mortgage interest rates. Therefore, the banks that are part of the Panel Bank project are requested to send their rates by 10:45AM (CET)27. The Euribor rate is calculated by Thompson Reuters in the way that it first elimenates15% off all quotes collected and round the average of the remaining ones to three decimals. Moreover, Eonia (Euro Overnight Index Average) is the effective overnight reference rate for the euro and is computed as the weighted average of all overnight unsecured lending transactions undertaken in the interbank market. This indicator uses the data from the same European banks as Euribor, but is also uses the help of the European Central Bank. The Eonia rate is calculated differently than Euribor as the ECB has to make it available to Thompson Reuters everyday between 6:00 and 7 pm so that the rates can be made public. In order to achieve the correct Eonia rate, the ECB computes all overnight28 unsecured lending transactions in the interbank market, initiated in the euro area. As it can be seen from the Euribor, Eonia and ECB main lending facility graphs, the 3 rates follow usually the same development pattern. This should come as no surprise as the ECB main lending facility rate plays a decisive role in setting Eonia rate and indirectly influencing Euribor.
28
www.euribor.org Overnight is defined as from one TARGET (i.e. day on which the Trans-European Automated RealTime Gross Settlement Express Transfer system is open) to the next TARGET day.
27
26
ECB main lending facility rate Chart 4
Eonia interest rate Chart 5
Euribor 12 month interest rate Chart 6 Source: http://www.euribor-rates.eu
In addition, the graphs also reveal the fact that before the beginning of the crisis, the Euribor 12 month interest rates were always with approximately 0.5 points higher than the ECB main lending facility rate. However, Eonia interest rate is influenced in a stronger way by the ECB main lending facility and thus it is closer to it, as can be observed from the graphs. The Euribor rate is very dependent on the evolution of the ECB main lending facility but also on that of the money markets. The interest rate the banks use for lending their customers has also a strong impact on the EURIBOR evolution as it represents more or less the demand factor for that market and implicitly the opportunity costs banks have to get more liquidity and invest it. Moreover, money markets influence the lending interest rate of banks by determining the level of competition banks are facing and also the opportunities investors have when accessing the debt channel. This makes banks lower their profit margins in favour of getting more customers and
27
3.1 The development of the European banking system until the beginning of the financial crisis
The year 2007 was the last one to be characterized by full credit growth. This fact can be argued by observing the monetary aggregate M3 and the lending to the private sector. One of the reasons for this growth could be the speculative demand for monetary assets driven by the constant increase of the interest rates of the ECB. On the same time, both the M1 rates and the loans to households grew only at a moderate pace, consequently strengthening the idea of a speculative growth for monetary assets.
Source: ECB annual report 2007 Chart 7
As it can be observed from the graph above, after 2004 the M3 aggregate and the loans started increasing in value due to the specific monetary policies used to recover from the slight downturn at the end of 2003 and beginning of 2004.
28
Source: ECB annual report 2007 Chart 8 Such specific monetary policies included low levels of interest rates, an increase in the growth of loans to the private sector and an increase in rates for highly liquid deposits (ex: overnight deposits)29. Moreover, the growth rate of credits continued to increase up until the fourth quarter of 2007 especially to the private sector. But the highest increase in loans could be observed in the private sector. Simultaneously, the MFI30s reduced a large part of their loan holdings by removing the general government debt securities from their portfolio. This phenomenon
29
ECB annual report 2005 pag. 24-26. According to the ECB website (www.ecb.eu): Monetary financial institutions" (MFIs) are central banks, resident credit institutions as defined in Community law, and other resident financial institutions whose business is to receive deposits and/or close substitutes for deposits from entities other than MFIs and, for their own account (at least in economic terms), to grant credits and/or make investments in securities. Money market funds are also classified as MFIs.
30
29
is historically typical for a period with rising short-term interest rates and funding costs.
Source: ECB annual report 2007 Chart 9 However, the most constant increase in loans can be observed in the sector of financial and non-financial companies. The increase in loans to non-financial institutions was due to general strong economic growth and a big increase in mergers and acquisitions. On the other hand there can be observed a moderation in the growth rate of household loans. This can be explained by the decreasing volume of loans for house purchasing due to the increase of the mortgage rates. The loans to households deserve a closer look as they are one of the most important parts of the private sector loans. Thus, analyzing this sector, we can observe that since 2003 until 2007 the volume of household loans and their value has been constantly increasing. Further in
30
depth analysis provide the observation that the main driver for such loans was still house purchasing. The total volume (amounts in billions of euro) of loans and deposits at the end of 2007 divided for each euro zone country is a federation important detail in the analysis of the European Banking sector before the impact of the global financial crisis. This graph clearly shows that the countries that are strongly influenced by the development of loans are Germany, Spain, France and Italy. In addition, the countries that are mostly influenced by the volume of deposits are the same four mentioned above (Germany, Spain, France and Italy) plus Luxemburg, which is also a big exception among the other countries as the volume of loans is by far greater than the one of deposits. Considering that the current financial crisis was mostly based on bank runs and lack of liquidity, this graph is thus crucial to determine the way in which the euro zone was affected. The countries with more deposits than credit loans such as Belgium, Greece and Luxemburg should have had a liquidity advantage over the others, but as there are always exception, Greece is one that defies this theory. Even if this paper does not analyze the particular situation of each euro zone country, it has to be mention that even so, Greece has developed the bad financial situation in which it is today due to bad fiscal policy. On the contrary, Luxembourg managed to escape the downfall of the crisis until recently and it is still managing to keep an almost steady economical growth rate despite the global financial turmoil. One could argue that this was and still is possible due to the amazing ration the country has for loans and deposits.
3.2 The effect of the financial crisis on the European banking system
The exact moment of the start of the financial crisis is difficult to point out as it usually happens with credit crunch crisis. One could argue that the first sign of the crisis was in July 2007 when Bear Sterns31, a New York city bank, announced that collapse of two of its hedge funds, thus having a loss of close to 1.5 billion USD.
www.marketwatch.com (http://www.marketwatch.com/story/milestones-meltdown-finance-ministerscentral-bankers)
31
31
For Europe, the dangers of a financial crisis became more visible on the 9th of August when the giant global bank BNP Paribas publically announced the ceasing of valuation of three of its funds and also suspended investor withdrawals. Moreover, another big step in the start of the credit crunch crisis was the bank run on The Northern Rock Bank on September 13th 2007 when The National Bank of England announced that it no longer provided emergency support to this particular financial institution. Five days later, the US Federal Reserve declared its first in 4 years reduction in its key rate of half of a point. The ECB made a similar announcement of reduction in its key interest rate on the 8th of October 2008 when it also reduced the rate by 0.5 points. Measuring the start of the crisis by the central banking indicators it would be fair to say that in Europe the financial turmoil started in October 2008 and rapidly developed in the next months, causing the ECB to reduce its key interest rate by 1.75 points in less than 2 months, an unprecedented drastic measure32. However, the beginning of the year 2008 did not disturb the financial systems with more important events similar to those mentioned previously. The ECB also maintained more stable key interest rates and thus induced a higher spread between the secured and unsecured money markets rates. By this time, the ECB emphasize as much as possible the separation between monetary policy decisions and liquidity management. Taking advantage of its flexibility offered by its implementation background, the ECB allocated liquidity in excess and increased the maturity of its operations by offering larger volumes of liquidity for long-term refinancing operations. This however, had negative consequence on the main refinancing operations. By using its monetary policy tools, the ECB managed to keep EONIA really close to the minimum bid rate in the main refinancing operations until September 2008. Until September 2008, the European markets were not influenced too much by the global economical development and the indicators such as those presented in the graph proved to be quite stable. Due to the increased stability in the unsecured markets the ECB Governing Council considered fit to increase the main refinancing operations interest rate on the 3rd
32
www.istockanalyst.com (http://www.istockanalyst.com/article/viewarticle/articleid/2702034)
32
of July 2008. The EONIA rate did not seem to be affected by this decision and was constant until the beginning of September that year.
Source: ECB annual report 2007 Chart 10 However, the European Banking system started to feel the coming crash as early as 15th of September when the collapse of the investment bank Lehman Brothers occurred and the 158 old bank filed for bankruptcy. Almost of the same time, another large financial company, Merrill-Lynch, for fear of a similar collapse, agreed to be taken over by Bank of America. 33
The banking sector in the Euro zone is saw a good and quick recovery thanks to the immediate response of the ECB to the liquidity gap. Profitability indicators such as the return on equity (ROE) and return on assets (ROA) sustain the conclusion that the
Source: ECB annual report 2007 Chart 11
banking sector managed to bounce back to levels that could be compared to those from 2006 and 2007. As it can be observed from the right hand side graph, the last quarter of 2008 was the most affected by the crisis as it was also the starting point of the financial crisis and so it was filled with important bankruptcies, or necessary mergers and acquisitions events.
34
However, the return on equity is still at a lower term than the one in 2006 and forecasts of the ECB33 predict that this situation will not change in the favour of the banks this year or maybe even the following one. Moreover, the return on assets is also on much lower levels than the ones in 2006 and the forecasts of the ECB for this financial indicator are similar to those of the ROE. T In conclusion, the impact of the financial crisis on the European banking system was very powerful. The levels of profit, volumes of credits and growth rate were brought down in a step manner by the global financial turmoil. Even if the issues in the European financial system occurred later than in the US, their impact was similar. The fact that the European Banking system was influenced at a later date, gave the ECB the chance to adapt quicker than the FED and thus it had the opportunity of managing the crisis in a better manner.
33
www.ecb.eu
35
Chapter 4. Empirical evidence of the usefulness of the monetary policy

The monetary policy of the ECB during the current financial crisis has always been described by the President of the ECB Mr. Jean-Claude Trichet as being appropriate in the present circumstances34 and he also stated that we never precommit: we always do what is appropriate to be able to tell our fellow citizens that we will deliver price stability in the medium term according to our mandate. This kind of policy ensured that the ECB had full flexibility over its key interest rates without making any future promises that would bind them to certain monetary policy measures. However, as mentioned in the previous chapters, the ECB monetary policy measures did not influence a particular country of the euro zone, but rather the region as a whole. Even so, the influence of the ECB cannot be denied when it comes to influencing the economical growth, the level of price stability and the unemployment rate of the 16 euro zone countries. This chapter will thus focus on answering questions related to the impact of the ECBs monetary policy on the development of the euro area over the last two and a half years. The answers will be presented by using a VAR economical model applied on the statistical data provided by the relevant databases35. Since the outbreak of the financial crisis in the euro zone the European Central Bank has taken different measures to try to support both the banking system and the European Economy. Such measures have been moderated at first and stared with a reduction in the key interest rates but after the financial crisis started to take a snow ball effect, the measures ranged from drastic reductions in the interest rates to substantial capital inflows in the form of main lending facilities. In order to determine the impact of the measures the European Central Bank took in order to minimize the effects of the crisis, we believe it is relevant to determine
34 35
www.ecb.eu (http://www.ecb.eu/press/pressconf/2008/html/is081106.en.html) Appendix 1
36
how three very important macroeconomic indicators are influenced by the ECB monetary policy instruments. Thus we will consider determining how, on a quarterly basis, the following variables are influenced: the economic growth rate, the inflation rate (HICP index), the unemployment rate.
The European Central Banking monetary policy tools, that are considered to have a considerable effect on the above mentioned macroeconomic indicators, are the following: ECB main lending facility rate, ECB main refinancing operations rate, ECB minimum reservers rate, The Euribor rate, M3 monetary aggregate percentage change, EONIA interest rate.
The choice of variables is based on the fact that the purpose of this empirical test and also of this paper is to investigate how efficient were the measures which the ECB took before, during and after the crisis. Therefore, the explained variables have been chosen to be representative for the period of time that was before, during and after the economical struggle in the euro zone. It is only these three macroeconomic indicators that have been chosen to present the economic development due to the fact that they are considered to be the most representative and the most significant in research papers and economical evaluation of the ECB. Moreover, the economic growth rate, the inflation rate and the unemployment rate are some of the main economical indicators that the ECBs official representatives mention to take into account in official statements at the monthly press conferences. So far, from the monetary and economical perspective, the actions taken by the ECB have proven to be both adequate and efficient. However, it is best to test these
37
measures with as many and as different tools as possible in order to avoid getting biased results. Therefore, we would like to present a model that will test the efficiency of the ECBs tools by regressing the financial indicators that measure the economic growth rate, the inflation rate, and the unemployment rate. In addition, the variables that influence these indicators are considered to be the following: the ECBs main lending facility rate, the ECBs main refinancing rate, the ECBs minimum reserve rates, the Euribor rate and last but not least - the EONIA rate. However, before considering the results of this regression, a series of tests will also be performed in order to verify the validity of the results36. Such tests include the normality test, the heteroskedascity test, etc. These tests will not only verify the validly of the data but will also confirm that the data and the results are consistent and reliable. The database used here was based on information disclosed by the ECB but adapted so that it shows the quarterly data since 1999 until the third quarter of 2010. The data was modified for some variables due to the differences in reporting of different financial indicators. For the financial indicators that are reported on a more frequent basis than quarterly data was obtained by making a simple average for that quarterly period. For processing the data and performing the above mentioned test, the eviews softare was used together with Microsoft excel for storing the data. As mentioned in the introduction there are certain delimitation concerning the data gathering and thus even though we have tried to process the latest provided information, there still have been some mismatches related to the data for the explanatory variables. Therefore, a compromise has been reached and all data has been aligned to the variable that misses the most recent information. The purpose of this chapter is thus to regress three main variables that show the condition of the economy and mainly of the banking system in the euro zone against the variables that the ECB can control to a certain, but high degree such as:

36
ECB main lending facility rate, ECB main refinancing operations rate,
Appendix 2
38
ECB minimum reserves rate, The Euribor rate, M3 monetary aggregate percentage change, EONIA interest rate.
The data for the euro zone has been collected, however, as the euro zone expanded, the data was always adapted to the changes and consequently each country's economy has a certain effect on the modification that are observed during some particular years. To sum up, the hypothesis for this analysis is: H0: the listed variables cannot explain the dependent variables H1: the listed variables can explain the dependent variables The equations used to explain dependable variables are presented below:
Economic growth t = + 1EC_main_lending facility + 2ECBmain_refinancing_facilityt + 3 ECB_minimum_reserves_rates t + 4M3t + 5Eonia__interest_rate t + 6QHICP + 7Qunemployment + t
Inflation rate t = + 1EC_main_lending facility + 2ECBmain_refinancing_facilityt + 3 ECB_minimum_reserves_rates t + 4M3t + 5Eonia__interest_rate t + 6QEconomic_Growth + 7Qunemployment + t
Unemployment rate t = + 1EC_main_lending facility + 2ECBmain_refinancing_facilityt + 3 ECB_minimum_reserves_rates t + 4M3t + 5Eonia__interest_rate t + 6QEconomic_Growth + + 7Qunemployment +t
After regressing the first equation in e-views we obtain the below results:
39
Figure 1 Just by observing the probabilities results it is easily observed that Euribor and the inflation rate should be excluded from this estimation. After doing so, the new regression will become the folowing one:
40
Figure 2 After implementing only the relevant variables, we can have a more detailed look at the rest of the results. Thanks to this analysis we can now state that the Economic growth equation is the following:
Economic growth t = - 11.49016 - 7.527669*ECB_main_lending facility + 13.84241*ECBmain_refinancing_facility 11.98722*ECB_minimum_reserves_rates + 0.347549*M3 + 7.044614*Eonia_interest_rate t + 1.705770*Qunemployment + t
The results shown above indicate that the main lending facility and the minimum reserves rate used by the ECB influence the Economic growth in a negative way. This means that when these rates decrease, the economic growth rate should increase, which is normal if we think that the minimum reserves rate oblige central banks to keep more money with the ECB and in turn this makes the commercial banks deposit more money with the central banks which leads to a decrease in liquidity and disencourages the commercial banks to provide more credits for the economy. Moreover, the M3 monetary indicator seems to have a rather large impact on the economic growth rate as it takes only an increase of 0.34% of this rate to impact a 1% 41
increase on the mentioned dependent variable.The R-squared of 0.83 indicates that the results are rather consistent as the data fits very well. Normaly, the R-squared indicator should have a value of over 0.60 so in this particular case the data is confirmed to be adequate. Regressing the second equation leads to the below results:
Figure 3 Again, we can observe by the values of the p-values that some explanatory variables are not consistent and should therefore be removed. After this corrections the new results are presented:
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Figure 4 Thus, the inflation equation is the following:
Inflation rate = 14.83941 4.730308*ECBmain_refinancing_facility + 1.758928*ECB_minimum_reserves_rates - 0.130760*M3t + 2.567140*Eonia_interest_rate - 1.265579*Qunemployment + t

The inflation rate seems to be more influenced by the rates of the ECB than the growth rate on a quarterly basis as the coefficients are obviously lower than for the former. The ECB can obviously influence the inflation indicator much better as it has more direct effect on it, just as any other central bank. What might appear as strange is that the ECBs main refinancing rate influences this indicator in a negative way. This could be explained by the fact that the banks are provided with less liquidity and thus it it more expensive to provide the commercial banks with funds they require. The same reasoning can be applied to explain the negative impact of the M3 monetary indicator over the inflation rate. In addtion, the R-squared indicator is again over 0.60 which validates the relevance of the collected data. However, the lower value might pose the question
43
wheather or not the presented information could be improved by deleting some of the variables, but the P-value of the presented ones infirms this. Last but not least, the below results are obtained after regression of the third equation
Figure 5 By eliminating the inconsistent explanatory variables, the new results will become the following:
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Figure 6 The equation for the unemployment rate that uses the above coefficients can now be written as follows:
Unemployment rate = 9.040431 + 2.177816*ECB_main_lending facility 4.809593*ECBmain_refinancing_facility + 2.140228*ECB_minimum_reserves_rates 0.153286*M3 + 0.084410*QEconomic_Growth - 0.1831508*QHICP +t
From the coefficients of this equation we can observe that again - the monetary indicator M3 is a very strong tool of the ECB to influence the macroeconomic indicators such as the unemployment rate. The other ECB economic indicators such as the ECBs main lending facility rate and the ECBs main refinancing facility rate have quite a strong impact on the evolution of the unemployment rate, as it takes only an increase of 2.18% of the ECBs main lending facility to influence a raise of 1% in the unemployment rate.
45
The high value of the R-square indicates that the collected data is consistent enough to lead to satisfying and relevant results. This is highly encouraging as the unemployment rate is not one of the indicators that the ECB mentions very often in its statistics but it still has a strong impact according to the data presented above. In conclusion, the actual impact of the ECBs measures seems to be relevant to the gathered data. The interest rates used by the ECB to influence the turn out of the macro-economic indicators are powerful enough to induce the desired effects. Even thought the data has been evaluated a as whole and not for particular periods of time, such as before and during the financial turmoil, the effects of the ECBs monetary tools appear to be just as relevant at any point in time. It can also be observed that during the crisis the drastic taken measure had usually the desired impact and managed to keep the financial indicators such as the inflation rate at a consistent level, with some exceptions. The empirical results presented in this chapter confirm the efficiency of the decisions of the ECB in terms of effect of the ECB interest rates over macro-economic financial indicators. The impact of the ECB interest rates is quite significant and this contributes further to the success of future decisions to be yet taken.
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Chapter 5. Was the American way better? A brief comparison between the ECBs and the Feds monetary policies
The purpose of this chapter is to briefly present the monetary decisions of the Fed in comparison with those of the ECB. However, as this paper is mainly about the ECBs monetary policy, the details about the Fed will be as brief as possible. Even so, we consider that in order to be able to reach appropriate and relevant conclusions, it is a must that the administrative structure of the Fed, its monetary policy decisions before and during the financial crisis are presented. Therefore, the limitations of this chapter will thus be in the perspective of the data collected and presented about the Fed, as it is not a main point of interest, but just a tool to view the decisions of the ECB in different perspective. To begin with, the Fed (short for Federal Reserve System) is the USs central bank. As the ECB, it is politically independent, but it is accountable to the Congress and its goals are set by the law. However, it is considered that its independence grants the fact that decisions are not in any way influenced by the decision makers who are involved in making the decisions concerning the public money. The Fed decisions makers are the ones in the Board of Directors in Washington plus a number of twelve Federal Reserve District Banks37. All seven governors of the Fed are appointed by the president of the US and after that confirmed by the Senate. However, the Reserve bank presidents are appointed for a governing term of 5 years by the Banks board of directors and then also approved by the Board of Directors. The criteria that are taking into consideration to choose such people are varied and thus make sure to include people from different regions of interest, different financial institutions, even non-financial business. The Fed is also structured to be self-sufficient from a financial point of view, and it meets its operating expenses primarily from the interest of earnings on its portfolio of securities.
37
http://www.frbsf.org/publications/federalreserve/monetary/goals.html
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Chart 11 The main responsibility of the Fed is to conduct the monetary policy of the United States of America. In order to insure that the best decisions are taken in regards to the monetary policy decisions the Federal Open Markets Committee meets in Washington eight times a year. The twelve members of this Committee are seven members of the Board of Governors, The president of the Federal Reserves Bank in New York and four of the other reserve bank presidents who participate in a rotational system. The other Reserve banks presidents contribute as well to the discussions and negotiations.
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Chart 12
38
Moreover, each director of the reserves banks has a responsibility to make recommendations about the appropriate discount rate that is finally subject to approval of the Governors. In contrast to the ECB monetary policy that has a main goal of keeping price stability below but close to 2%, the Fed has two monetary objectives. The first one is to promote maximum sustainable output and employment. The second objective refers to stable prices. In a more detailed explanation, the first goal refers to the correlation between factors like technology and people's preferences for saving, risk, and work efforts that insure maximum output and employment and the monetary decisions of the Fed to make sure this is possible in the long run. However, the fact that the economy is subject to a cyclic effect, and thus both output and employment are affected, is taken into consideration and therefore the expectations of towards the Feds monetary policy are to intervene more in the long run to adjust such economical draw-backs by pushing down the interest rates. Therefore its role is considered to be, as for most central banks, the one of ensuring a smooth economy life.
38
http://www.doctorhousingbubble.com/treasury-federal-reserve-banking-money-structure-bailout-tarp/
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However, an interesting aspect of the two monetary policy objectives is that sometimes they are in conflict. Such an example is the one of financial crisis in which the Fed should ensure low unemployment rates and steady inflation rates. In such situations there is also a lot political pressure that manifests itself towards either long term stability such as inflation or short term unemployment control. Nevertheless, its independence grants the Fed enough power to be able to maintain a good balance between the two and ensure overall stability. As the ECB is responsible for the economical stability of the whole euro region, so is the Fed responsible for the whole US region. Even tough, similar to the ECB, the Fed cannot intervene to help a particular region, it still relies on all regional data and info and always takes this into account when making general federal decisions. Similar to the ECB, the Fed has specific monetary tools that support this institution influence output, inflation and unemployment. Such rates are the bank reserves rates, the federal funds market, the open market operations, the discount rate and last but not least the foreign currency operations. The bank reserves are the cash deposits that all banks are obliged to keep with the central bank. No further details will be provided as they are the same as presented for the ECB. The federal funds market is similar to the one in Europe where banks lend to each other money at different interest rates, regulated as well by the Fed. The rate for these overnight borrowings of reserves is simply influenced by the demand and offer market.
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Chart 13
The open market operations are the major tool used by the Fed to influence the economic indicators. This means that the Fed actually buys and sells government securities on the open market, but only through the Federal Reserve Bank of New York.If the Fed wants to decress the rate it just buys more government securities from a bank. The way it pays for those securities is to increase the banks reserves. The bank can thus use the extra resereves provided by the Fed to lend to another bank on the federal funds market. The discount rate is the rate that banks have to pay when borrowing money directly from the Fed through the primary credit system.
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Chart 14 These rates are always set by the Board of Directors but are carefully reviewed also by the Directors of the reserves Banks39. The types of credits known as the secondary credit types rates are given in much stricter conditions to institutions that do not meet the conditions for the primary type of credit.
Another important tool that the Fed has at hand is the foreign currency operations. When using these kinds of operations, the Fed is in strong cooperation relations with the Treasury which usually has general responsibility over this matter. The Fed usually gets involved in these operations to control the speculative movements in foreign currencies and prevent potential currency attacks that might affect the value of the USD and consequently influence the well being of the whole economy. Another important aspect on which the Fed and the Treasury collaborate on is the money supply. As it can see below, this indicator was generally adapted to the
39
Appendix 3
52
present economical conditions and, as the ECB increased the money supply to unseen levels, a similar decision was taken by the Fed as well.
Chart 15
40
So far we can observe a lot of similarities between the ECB and the Fed. They are both in charge of ensuring prices stability for large monetary areas, they both have very similar objectives and both institutions have quite similar tools and procedures to intervene and smooth the economical trends. Even though at first sight, the Fed seems to have lowered the rates faster and started pumping money in the economy quicker than the ECB, after a more considerate approach we can observe that this is not really true. An obvious reason is the fact the in July 2009 the ECB injected 442 billion euros in the euro market. This is considered to
http://raymondpronk.wordpress.com/2009/10/28/the-coming-inflation-and-a-new-money-supplybacked-my-real-estate-free-enterpris
40
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be the largest capital injection and in comparison to the Feds efforts this is twice as much capital as the American institution ever injected in the local economy. The ECB has also been supporting the fiscal policies more ferociously by debt monetisation and taking bigger risks with its public credibility and solvency liquidity. The modern way of actually printing money and thus helping the economy and mostly the commercial and investment banks, is to take one more liability. More specifically, the national banks have been taking on liabilities of more over 1.2 trillion in the US and 1.5trillion in the euro zone. Given the fact that US has a GDP higher by 12% than the euro zone, this means that the ECB has been providing twice as much money than the US. In addition, as mentioned before, the Fed has also been very actively involved in the debt monetisation. This has been generally perceived as a much more unprudent way of expanding the balance sheet than the ECB. Moreover, the American institution has been purchasing government and agency bonds outright, therefore having an opened exposure to unpredicted capital losses due to higher interest rates which would consequently bind it to further commitments and thus infringe from developing certain monetary policies. Nonetheless, even when the US government deficit was in big trouble, the Fed was willing to buy the Treasury bonds, therefore taking on additional unnecessary risk. In contrast the ECB has not been willing to take on long term debt commitments and did not engage in transactions with dubious corporate assets. We can thus say that the ECB has mostly expanded its balance sheet by lending money to euro zone banks as the Fed has been more active in purchasing government and agency bonds. However, it must also be taken into consideration that the path ECB has chosen is not as safe as the financial institution claims to be. Since the begging of the credit crunch credibility in the banking system has seriously deteriorated and the collateral provided by the banking institutions has consequently deteriorated in less safe guarantees. It is also worth mentioning that the ECB has been les reluctant than the Fed and the Bank of England in accepting lower quality public bonds. The two other central banking institutions have been accepting only AAA rated public bonds as relevant collateral for their public operations. The ECB however, has been lending funds against 54
low-rated mortgage bonds and commercial loan books or other less trust worthy assets that are normally considered by the financial market as toxic if the ECB had not have turned them into cash. For having the courage to do this the ECB has been regarded as a saver of less lucky governments such as eland, Greece, Portugal, Spain and Austria. Even so, these countries are still in more financial distress than the other euro zone governments. The commercial banks in these financially struggling countries had thus the possibility to buy unlimited quantities of government bonds with the funds provided by the ECB. Moreover, these bonds have also been used to get even more ECB funds that could be put to use for buying even more local government bonds. The ECB has thus been lending unbelievable large amounts of money to governments that have been in financial distress by the help of the local commercial banks. The big risk of default of local banks and governments has thus been taken on the ECBs side. The effect of the economic downturn in mid 2010 was most obvious in the labour market as it deteriorated both in US and Europe.
Chart 16 55
As it can easily be seen from the graph presented above the immediate impact of labour market deterioration was that the hourly labour costs plunged in both markets. Even though in Europe there was a slight delay for this effect, the monetary decisions of the ECB and Fed could not stop this process from happening. Another explanation for the delay is that wages are set at a lower pace in Europe than in US. Moreover, the wages and benefits of about half of the labour force in US is in strong connection with the Consumer Price Index. As this indicator started to go down, the wages decreased as indexed to the inflation. In addition, the unemployment rate increased sharply in US in comparison to the Euro zone. Continuing the trend from 2007 the unemployment rate raised to 9.7% in March 2010, in spite of all the measures taken by the Fed. Simultaneously, the unemployment rate in the euro zone started to increase only in 2008 and no more than 3 percentage points, to a level f 10% in March 2010.
Chart 17 The high increase in the unemployment rate can also be explained less employment protection measures that are not obviously connected to the works of the
56
Fed. Therefore, the difference in legislation contributed to this difference in how the labour market behaved in the two zones. In July 2010 the unemployment problem accentuated even more in both areas despite the monetary financial measures taken by the central banks. In the euro zone the effect of this issue could be more visible in the economical life as it contributed to a decline in the real GDP of more than 5.3% while it led to a similar decrease of only 3.7% in the US.
Chart 18 As it can be observed, both economies had a lot to suffer in the sector of average and total hours worked. This should not be surprising as the monetary policy effects can be seen with a considerable lag on this market. Therefore, for the last period of time the labour market has actually stabilized and even shows signs of improvement in both regions. 57
However, when looking at other indicators such as the output growth and the inflation rate, the Fed seems to have been able to control the indicators better than the ECB. The figures for the worldwide most important economies seem to be mostly in favour of the US. Even though the biggest impact was on this particular economy, the measures taken by the fiscal authorities in correlation with the monetary policies of the Fed and the Treasury institution have so far proven to be the most effiecient in comparison to the euro, Japanese and UK ones. The differences are not big, but on the long term they might prove to be a significant difference.
Chart 19 58
Nevertheless, the monetary policy decision in the regions can also be compared by the development of the exchange rates of the two currencies. For example, the euro currency weekend more than the USD during the year 2009. This is another confirmation that the US economy had a better recovery rate. In conclusion it is difficult to say if the Fed managed the financial crisis better as its decisions were not the only decisive factors that influenced this economical evolution. However, when comparing the financial indicators such as the inflation rate, unemployment rate, economic growth rate, output development, it can be seen that the US zone recovered faster than the euro zone. So in terms of macro-economical indicators the Fed appears to have managed the crisis in a better way. It can be argued that this institution has a lot more experience in dealing with financial crisis at such level than the ECB. After all, it has already seen the effects of the Great Depressions, as the ECB has only started functioning as a central bank for a region such as the euro zone for the last 10 years. Moreover, the US did not have to deal with integration of new member states and consequently economical adjustments as the ECB did. And even if the political independence is guaranteed to both institutions, the management of this factor also differs a lot between the two regions as there are a lot more particular regional different interests in the euro zone than in the US. All this being taken into account it is safe to say that the management of the financial crisis was handled as best as possible by both central banking institutions and very important monetary policy lessons have been learned from this experience. In this perspective, the new rules of a new Basel agreement have already started to show quite prominently.
59
Conclusions
As mentioned in the beginning the purpose of this paper was to research the details of the ECBs monetary policy and present its monetary decisions in the perspective of the last ten years, with a special focus on the financial crisis and the management of this situation. The comparisons made between the monetary policy of the ECB before and after the start of the crisis, together with the empirical evidence analysed here, as well as the brief comparison with the Fed, the US central bank, has proven that the ECB is a complex decision making organization that has taken radical decisions when necessary but still preserved the image of a very prudent institution. In the beginning of this paper we have tried to explain the administration details and functioning of the European Central Bank. We have presented the main instruments used to control and influence the euro zone financial life before and during the financial turmoil. The special focus has always been on the last two and a half years, ever since the worldwide economies started taking a downturn and the perspectives of economical growth and development declined and diminished to unpredictable dangerous levels. The presentation of the ECBs administrative organization had the purpose of providing all the necessary information to better understand how it was possible for this central bank to intervene in certain ways or why it did not take action at certain points. Moreover, the next focused more on the European banking system so that the influence of the ECB could clearly be seen on this sector. The focus was on the banking system mostly because this was one of the most affected sectors of the economy and it is also believed to be one of the main factors for the expansions in such a drastic and rapid way of the financial crisis. The special interest for the presentation of the European banking system was again on the last two and a half years. The influence of the banking system on the economy but also the way in which the ECB intervened for supporting the commercial and investment banks to sustain a healthy economical life was one of the main reasons for investigating this matter in such a specific way. The theoretical aspect being covered, the paper focused on the empirical evidence and presented the impact of the different monetary tools of the ECB in over the economical life in the euro zone by showing revelling facts and concrete aspects of this. 60
Nevertheless, the comparison with the US central bank, the Fed, has proven equally important for the correct evaluation of the decisions concerning the monetary policy of the EBC. This comparison was relevant as useful as it showed that the Feds monetary policy decisions were quite different from the ones of the ECB and in certain circumstance even proved to be more efficient. Although there are a lot of factors to be taken into consideration when it comes to evaluating the financial recovery of the euro zone and that of the US, the monetary policy is considered to play a major part as its impact on the inflation, unemployment, economic growth, and other important financial and macro-economic indicators is undeniable. Therefore, the study of this paper attempts to present the monetary decision of the ECB from as many perspectives as possible. This is meant to ensure the objectivism of the paper but also provide as much complete data as possible. The conclusion of this paper is that the ECB still lacks experience as a central bank for a large region and it is still to be faced with different future unpredictable economical aspects. However, taken into consideration the fact the it has staring working as a true central bank for several countries for just 10 years, it is remarkable how it managed to deal with the political, economical, social and financial challenges that have developed since the start of its activity.
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Appendix 1
QECB QECB Main Main refinancing lending operations facility 3 4,226563 3,592308 2,546154 3,5 2,5 3,807692 2,807692 4,2 3,2 4,810484 3,810484 5,330769 4,330769 5,734127 4,734127 5,75 4,75 5,604839 4,604839 5,35 4,35 4,480159 3,480159 4,25 3,25 4,25 3,25 4,25 3,25 4,130952 3,130952 3,68254 2,68254 3,362903 2,362903 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3 2 3,073077 2,073077 3,320313 2,320313 3,548387 2,548387 3,896154 2,896154 4,265873 3,265873 4,550781 3,550781 4,802419 3,802419 5 4 5 4 5 4 5 4 5,227273 4,227273 3,90625 3,398438 QECB minimum reservers rate 3 2,615077 2,5 2,747077 3,134308 3,702258 4,387846 4,759048 4,766875 4,664032 4,432615 3,579683 3,307742 3,309524 3,297273 3,213651 2,774762 2,469032 2,073788 2,027121 2,009545 2 2,01 2,033538 2,06 2,05 2,05 2,060154 2,300313 2,570645 2,880769 3,205714 3,556875 3,810161 4,069231 4,156406 4,159194 4,199844 4,258939 3,943594 Q12 QEONIA month EURIBOR rate rate 3,05381 3,048531 2,608615 2,759615 2,465758 3,18947 2,831385 3,733831 3,283538 4,114323 3,984677 4,74929 4,438769 5,192677 4,805238 5,107857 4,83875 4,543906 4,740806 4,437935 4,340769 4,072492 3,628571 3,289111 3,280645 3,626032 3,324286 3,89873 3,304091 3,446742 3,240635 3,015016 2,766825 2543,661 2,441774 2232,759 2,065455 2197,22 2,016667 2281,272 2,018889 2,144222 2,039531 2,287172 2,053333 2,346697 2,080462 2,314292 2,064194 2,318823 2,069231 2,185862 2,075758 2,204288 2,145231 2,631277 2,402813 2,956047 2,634677 3,315645 2,941846 3,622785 3,362698 3,858413 3,609063 4,087656 3,855323 4,381048 4,046938 4,649538 3,950656 4,676531 4,045065 4,47571 4,000844 5,054453 4,252712 5,367788 3,173031 4,378688 QHICP 0,871875 1 1,166667 1,535385 1,9 1,841935 2,161538 2,465079 2,0375 2,867742 2,370769 2,073016 2,535484 2,068254 2,065152 2,3 2,328571 1,930645 2,063636 2,057576 1,736508 2,301563 2,233333 2,332308 2,032258 2,066154 2,333333 2,330769 2,296875 2,5 2,138462 1,795238 1,834375 1,9 1,856923 2,920313 3,356452 3,660938 3,80303 2,33125 QM3 5,901563 5,6 5,866667 5,636923 5,544615 5,296774 4,441538 4,065079 3,865625 4,585484 6,14 7,711111 7,541935 7,44127 6,998485 6,963492 7,888889 8,730645 8,237879 7,451515 6,3 5,26875 5,6 6,138462 6,6 7,24 8,137879 7,595385 7,917188 8,722581 8,1 9,166667 10,475 10,67903 11,67077 12,1625 11,1371 10,13906 8,937879 8,026563 Qunemployment 9,610938 9,45 9,25 8,995538 8,758154 8,521935 8,35 8,149365 8,01 7,984032 7,995846 8,106825 8,179032 8,335556 8,492273 8,623175 8,78619 8,796935 8,813333 8,861667 8,928254 8,959844 9,003333 9,027077 9,06 9,029692 8,946364 8,835692 8,734531 8,46 8,197077 7,984762 7,703438 7,513065 7,438769 7,331563 7,236774 7,379219 7,575 8,017344 Qeconomic growth, 2,11 2,33 2,98 3,98 4,27 4,59 3,85 3,39 2,9 2,03 1,62 1,02 0,51 0,91 1,19 1,17 0,96 0,5 0,65 1,17697 1,72 2,055938 2,07 1,79 1,44 1,63 1,94 2,14 2,69 3,14 3,12 3,45 3,45 2,71 2,68 2,16 2,14 1,41 0,37 -1,89
Date 1999Q1 1999Q2 1999Q3 1999Q4 2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2 2001Q3 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q4 2005Q1 2005Q2 2005Q3 2005Q4 2006Q1 2006Q2 2006Q3 2006Q4 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4
67
2009Q1 2009Q2 2009Q3 2009Q4 2010Q1
2,880952 1,987903 1,75 1,75 1,75
1,984127 1,129032 1 1 1
2,166667 1,241935 1 1 1
1,374 0,771565 0,356266 0,35271 0,343048
2,218381 1,67321 1,336939 1,238646 1,22373
0,957143 0,158065 -0,40758 0,432308 1,150794
5,688889 4,151613 2,374242 -0,09692 -0,15
8,814286 9,33 9,66197 9,853385 9,96
-5,03 -4,9021 -4,07 -2,16
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Appendix 2 Whites test statistic for economic growth is asymptotically distributed as a 2 with degrees of freedom equal to the number of slope coefficients, excluding the constant, in the test regression (26 in this example). With the help of e-vies we can observe also that the appropriate scalar of the chi function is 38.8851386598 higher than obs r sqared so we cannot reject the null hypothesis of no heteroskedasticity with a probability of being wrong of 0.10
White Heteroskedasticity Test: F-statistic Obs*R-squared 2.678352 35.36629 Probability Probability 0.019324 0.103953
Test Equation: Dependent Variable: RESID^2 Method: Least Squares Sample: 1999Q1 2009Q4 Included observations: 44 Variable C QECB_MAIN_LENDING_FACILI QECB_MAIN_LENDING_FACILI^2 QECB_MAIN_LENDING_FACILI*QECB_M AIN_REFINANCING_OP QECB_MAIN_LENDING_FACILI*QECB_MI NIMUM_RESERVERS_R QECB_MAIN_LENDING_FACILI*QEONIA_ RATE QECB_MAIN_LENDING_FACILI*QM3 QECB_MAIN_LENDING_FACILI*QUNEMP LOYMENT QECB_MAIN_REFINANCING_OP QECB_MAIN_REFINANCING_OP^2 QECB_MAIN_REFINANCING_OP*QECB_ MINIMUM_RESERVERS_R QECB_MAIN_REFINANCING_OP*QEONIA _RATE QECB_MAIN_REFINANCING_OP*QM3 QECB_MAIN_REFINANCING_OP*QUNEM PLOYMENT QECB_MINIMUM_RESERVERS_R QECB_MINIMUM_RESERVERS_R^2 QECB_MINIMUM_RESERVERS_R*QEONI A_RATE QECB_MINIMUM_RESERVERS_R*QM3 QECB_MINIMUM_RESERVERS_R*QUNE MPLOYMENT QEONIA_RATE Coefficient -1592.889 3650.317 -484.0638 2321.678 -1455.050 131.4154 2.515107 -284.4453 -5138.791 -1604.276 1303.639 -429.1944 1.776087 294.1576 1466.807 -27.22107 198.9576 3.118010 -3.444233 -165.3305 Std. Error 980.7247 2190.338 336.6720 885.4607 563.2386 267.4673 19.03060 215.8190 3055.844 533.9788 531.1399 296.8700 25.30088 252.1682 882.5937 64.40565 88.50111 7.427494 38.10271 256.5510 t-Statistic -1.624196 1.666554 -1.437791 2.622000 -2.583363 0.491333 0.132161 -1.317981 -1.681627 -3.004381 2.454418 -1.445732 0.070199 1.166513 1.661927 -0.422650 2.248081 0.419793 -0.090393 -0.644435 Prob. 0.1227 0.1139 0.1686 0.0178 0.0193 0.6295 0.8964 0.2050 0.1109 0.0080 0.0252 0.1664 0.9449 0.2595 0.1149 0.6778 0.0381 0.6799 0.9290 0.5279
69
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru QEONIA_RATE^2 QEONIA_RATE*QM3 QEONIA_RATE*QUNEMPLOYMENT QM3 QM3^2 QM3*QUNEMPLOYMENT QUNEMPLOYMENT^2 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 48.42154 -5.295211 7.547025 -38.75160 0.005722 3.574834 12.76436 0.803779 0.503677 0.690673 8.109493 -25.22790 1.965193 33.69208 4.687308 28.36829 20.63880 0.266738 3.120152 9.652745 1.437179 -1.129691 0.266037 -1.877609 0.021451 1.145724 1.322355 0.1688 0.2743 0.7934 0.0777 0.9831 0.2678 0.2036 0.740543 0.980371 2.373996 3.468839 2.678352 0.019324
Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)
The same function is run as before but for the relevant data for the inflation rate this tiem. Here we can observe a scalar of 37.5662347866 which is again higher than the obs R squared so we can reject the H0 of heteroskedasckysity for a level of 10% White Heteroskedasticity Test: F-statistic Obs*R-squared 3.235198 32.82467 Probability Probability 0.003496 0.035266
Test Equation: Dependent Variable: RESID^2 Method: Least Squares Sample: 1999Q1 2010Q1 Included observations: 45 Variable C QECB_MAIN_REFINANCING_OP QECB_MAIN_REFINANCING_OP^2 QECB_MAIN_REFINANCING_OP*QECB_ MINIMUM_RESERVERS_R QECB_MAIN_REFINANCING_OP*QEONIA _RATE QECB_MAIN_REFINANCING_OP*QM3 QECB_MAIN_REFINANCING_OP*QUNEM PLOYMENT QECB_MINIMUM_RESERVERS_R QECB_MINIMUM_RESERVERS_R^2 QECB_MINIMUM_RESERVERS_R*QEONI A_RATE QECB_MINIMUM_RESERVERS_R*QM3 QECB_MINIMUM_RESERVERS_R*QUNE MPLOYMENT QEONIA_RATE Coefficient -6.115573 -3.341444 -31.07769 33.43533 29.31378 -0.777143 0.575662 -48.03516 -5.285436 -21.98824 0.924157 4.676704 53.18493 Std. Error 70.08698 83.65022 27.35584 30.46520 20.86020 1.608504 7.189138 76.32676 6.087456 15.36837 1.394463 6.623428 45.03414 t-Statistic -0.087257 -0.039945 -1.136053 1.097493 1.405249 -0.483147 0.080074 -0.629336 -0.868250 -1.430746 0.662733 0.706085 1.180991 Prob. 0.9312 0.9685 0.2672 0.2833 0.1728 0.6334 0.9368 0.5351 0.3939 0.1654 0.5138 0.4869 0.2492
70
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru QEONIA_RATE^2 QEONIA_RATE*QM3 QEONIA_RATE*QUNEMPLOYMENT QM3 QM3^2 QM3*QUNEMPLOYMENT QUNEMPLOYMENT QUNEMPLOYMENT^2 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat -4.240732 -0.035471 -5.625156 0.121762 -0.046155 0.032002 0.167274 0.062348 0.729437 0.503968 0.246947 1.463583 13.22771 2.111025 3.250087 0.532275 4.324006 2.978369 0.032625 0.265277 12.22583 0.535372 -1.304806 -0.066640 -1.300913 0.040882 -1.414715 0.120636 0.013682 0.116458 0.2043 0.9474 0.2056 0.9677 0.1700 0.9050 0.9892 0.9083 0.197748 0.350629 0.345435 1.188544 3.235198 0.003496
Here, the same tests are done for the unemployment rate. In this case, the scalar is of 40.1132720694 White Heteroskedasticity Test: F-statistic Obs*R-squared 2.912398 36.56087 Probability Probability 0.014451 0.103560
Test Equation: Dependent Variable: RESID^2 Method: Least Squares Sample: 1999Q1 2009Q4 Included observations: 44 Variable C QECB_MAIN_LENDING_FACILI QECB_MAIN_LENDING_FACILI^2 QECB_MAIN_LENDING_FACILI*QECB_M AIN_REFINANCING_OP QECB_MAIN_LENDING_FACILI*QECB_MI NIMUM_RESERVERS_R QECB_MAIN_LENDING_FACILI*QECONO MIC_GROWTH_ QECB_MAIN_LENDING_FACILI*QHICP QECB_MAIN_LENDING_FACILI*QM3 QECB_MAIN_REFINANCING_OP QECB_MAIN_REFINANCING_OP^2 QECB_MAIN_REFINANCING_OP*QECB_ MINIMUM_RESERVERS_R QECB_MAIN_REFINANCING_OP*QECON OMIC_GROWTH_ Coefficient 17.39983 -36.35783 19.32079 -80.44749 46.67580 -0.125605 -5.700716 -2.725512 75.43572 57.09246 -38.99732 0.802088 Std. Error 6.352152 13.68146 7.603451 32.60867 22.56817 0.863477 3.942554 1.187248 31.28518 27.64635 27.33702 1.024171 t-Statistic 2.739203 -2.657452 2.541056 -2.467059 2.068213 -0.145464 -1.445945 -2.295655 2.411228 2.065099 -1.426539 0.783158 Prob. 0.0146 0.0172 0.0218 0.0253 0.0552 0.8862 0.1675 0.0355 0.0283 0.0555 0.1729 0.4450
71
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru QECB_MAIN_REFINANCING_OP*QHICP QECB_MAIN_REFINANCING_OP*QM3 QECB_MINIMUM_RESERVERS_R QECB_MINIMUM_RESERVERS_R^2 QECB_MINIMUM_RESERVERS_R*QECO NOMIC_GROWTH_ QECB_MINIMUM_RESERVERS_R*QHICP QECB_MINIMUM_RESERVERS_R*QM3 QECONOMIC_GROWTH_ QECONOMIC_GROWTH_^2 QECONOMIC_GROWTH_*QHICP QECONOMIC_GROWTH_*QM3 QHICP QHICP^2 QHICP*QM3 QM3 QM3^2 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 6.510311 2.792333 -43.87001 -3.668859 -0.638423 -0.822128 -0.065058 0.147810 -0.022108 -0.019250 0.001970 5.451141 0.059984 0.018544 2.649412 0.001524 0.830929 0.545621 0.018779 0.005643 134.7219 2.011028 4.073179 1.175891 22.49565 4.665390 0.425217 0.311883 0.106501 0.803840 0.011270 0.020937 0.005420 3.974502 0.029053 0.010092 1.195605 0.002900 1.598337 2.374652 -1.950155 -0.786399 -1.501405 -2.636015 -0.610871 0.183881 -1.961647 -0.919419 0.363389 1.371528 2.064631 1.837444 2.215960 0.525436 0.1295 0.0304 0.0689 0.4431 0.1527 0.0180 0.5499 0.8564 0.0674 0.3715 0.7211 0.1891 0.0556 0.0848 0.0415 0.6065 0.020541 0.027859 -4.850998 -3.715604 2.912398 0.014451
Autocorrelation test The autocorrelation tests run for the economic growth reveals the F test of f(2;35) has a value of 3.267424 which is lower than the value of our f statistic of 3.437840. This leads to the conclusion that there is no autocorrelation for a trust interval of 5%.
Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.437840 7.224479 Probability Probability 0.043337 0.026991
Test Equation: Dependent Variable: RESID Method: Least Squares Presample missing value lagged residuals set to zero. Variable C QECB_MAIN_LENDING_FACILI QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QEONIA_RATE Coefficient -4.600630 -2.825460 2.417370 0.664043 0.010781 Std. Error 7.394614 3.201350 4.942023 2.181996 1.249966 t-Statistic -0.622160 -0.882584 0.489146 0.304328 0.008625 Prob. 0.5379 0.3835 0.6278 0.7627 0.9932
72
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru QM3 QUNEMPLOYMENT RESID(-1) RESID(-2) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.092391 0.693985 0.555435 -0.056605 0.164193 -0.026849 0.882105 27.23385 -51.87926 1.857894 0.145136 0.784671 0.230725 0.217887 0.636583 0.884427 2.407353 -0.259791 0.5285 0.3825 0.0215 0.7965 -8.68E-15 0.870497 2.767239 3.132187 0.859460 0.558826
The same test as above is done for the inflation rate. In this case the value of the f test is f(2;366)= 3.259446 which is lower than the f statistic obtained by running the LM test in e-views. The f statistic value is of 3.834057, so again we can mention no autocorrelation for a 5% trust interval. Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 3.834057 7.725089 Probability Probability 0.030674 0.021014
Test Equation: Dependent Variable: RESID Method: Least Squares Date: 08/26/10 Time: 10:12 Presample missing value lagged residuals set to zero. Variable C QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QEONIA_RATE QM3 QUNEMPLOYMENT RESID(-1) RESID(-2) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient -1.253365 2.532075 -1.581673 -0.836967 0.036989 0.087923 0.549637 0.033901 0.171669 0.014957 0.446338 7.371043 -23.14741 1.728779 Std. Error 3.601228 1.547847 1.001220 0.625421 0.061410 0.324436 0.203772 0.174550 t-Statistic -0.348038 1.635869 -1.579746 -1.338246 0.602333 0.271003 2.697306 0.194217 Prob. 0.7298 0.1103 0.1227 0.1890 0.5506 0.7879 0.0105 0.8471 2.74E-15 0.449714 1.384329 1.705514 1.095445 0.386187
The same test as above is done for the unemployment rate. In this case the value of the f test is f(2;366)= 3.267424 which is lower than the f statistic obtained by running the LM test in e-views.
73
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru The f statistic value is of 6.183296, so again we can mention no autocorrelation for a 5% trust interval. Breusch-Godfrey Serial Correlation LM Test: F-statistic Obs*R-squared 6.183296 11.48763 Probability Probability 0.005017 0.003203
Test Equation: Dependent Variable: RESID Method: Least Squares Presample missing value lagged residuals set to zero. Variable C QECONOMIC_GROWTH_ QECB_MAIN_LENDING_FACILI QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QHICP QM3 RESID(-1) RESID(-2) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient -0.255564 -0.036502 0.141415 0.740333 -0.854504 0.045784 0.006208 0.740865 -0.267647 0.261083 0.092187 0.138134 0.667831 29.70070 1.965469 Std. Error 0.310803 0.019510 0.339753 0.666978 0.446467 0.042225 0.011769 0.211481 0.181570 t-Statistic -0.822271 -1.870958 0.416230 1.109981 -1.913925 1.084285 0.527512 3.503220 -1.474074 Prob. 0.4165 0.0697 0.6798 0.2746 0.0638 0.2857 0.6012 0.0013 0.1494 -1.55E-16 0.144978 -0.940941 -0.575993 1.545824 0.177235
Ramsey test Last but not least, the Ramsey test is performed to check the stability of the data First we will perform this test for the economic growth rate. Here we can see that the f test for the economic growth rate is f(6;31)= 2.409432 which is obviously lower than the value of our f statistic of 4.343518 for a trust interval of 5%.
Ramsey RESET Test: F-statistic Log likelihood ratio 4.343518 26.84596 Probability Probability 0.002715 0.000155
Test Equation: Dependent Variable: QECONOMIC_GROWTH_ Method: Least Squares Sample: 1999Q1 2009Q4
74
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru Included observations: 44 Variable C QECB_MAIN_LENDING_FACILI QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QEONIA_RATE QM3 QUNEMPLOYMENT FITTED^2 FITTED^3 FITTED^4 FITTED^5 FITTED^6 FITTED^7 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 0.948940 -3.301323 4.844328 3.092735 -4.717877 -0.012596 0.579036 -1.374285 0.589604 0.125834 -0.051472 -0.003116 0.001206 0.912412 0.878507 0.755669 17.70208 -42.40213 1.229680 Std. Error 12.09736 7.510959 13.10783 9.927457 6.222180 0.323950 1.591810 0.278881 0.218706 0.031267 0.017547 0.000885 0.000409 t-Statistic 0.078442 -0.439534 0.369575 0.311533 -0.758235 -0.038882 0.363759 -4.927858 2.695869 4.024540 -2.933372 -3.523176 2.947155 Prob. 0.9380 0.6633 0.7142 0.7575 0.4540 0.9692 0.7185 0.0000 0.0112 0.0003 0.0063 0.0013 0.0060 1.504337 2.167982 2.518279 3.045426 26.91081 0.000000
Moreover, we can see that the f test for the inflation rate is f(4;35)= 2.112765 which is obviously lower than the value of our f statistic of 2.180866 for a trust interval of 10%.
Test Equation: Dependent Variable: QHICP Method: Least Squares Sample: 1999Q1 2010Q1 Included observations: 45 Variable C QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QEONIA_RATE QM3 QUNEMPLOYMENT FITTED^2 Coefficient 17.13985 -6.176035 2.775372 3.117041 -0.123494 -1.422917 -6.869471 Std. Error 110.0731 35.43332 13.19952 19.21117 0.988586 9.490064 12.81977 t-Statistic 0.155713 -0.174300 0.210263 0.162251 -0.124920 -0.149938 -0.535850 Prob. 0.8772 0.8626 0.8347 0.8720 0.9013 0.8817 0.5955
75
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru FITTED^3 FITTED^4 FITTED^5 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 8.544897 -3.691808 0.530285 0.746786 0.681673 0.451134 7.123252 -22.37803 1.727644 9.315244 3.046554 0.369225 0.917303 -1.211798 1.436209 0.3653 0.2337 0.1598 1.993148 0.799593 1.439023 1.840504 11.46921 0.000000
In adition, we can see that the f test for the unemployment rate is f(3;34)= 2.882604 which is obviously lower than the value of our f statistic of 5.800866 for a trust interval of 5%.
Test Equation: Dependent Variable: QUNEMPLOYMENT Method: Least Squares Date: 08/26/10 Time: 10:50 Sample: 1999Q1 2009Q4 Included observations: 44 Variable C QECONOMIC_GROWTH_ QECB_MAIN_LENDING_FACILI QECB_MAIN_REFINANCING_OP QECB_MINIMUM_RESERVERS_R QHICP QM3 FITTED^2 FITTED^3 FITTED^4 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient -5634.456 -69.01847 -1781.200 3933.128 -1749.880 149.6843 125.3687 142.3419 -10.95214 0.314733 0.968278 0.959881 0.132600 0.597812 32.13740 1.794239 Std. Error 1567.215 19.12061 493.3769 1089.499 484.7466 41.47317 34.73280 39.86653 3.107603 0.090554 t-Statistic -3.595203 -3.609638 -3.610222 3.610032 -3.609886 3.609185 3.609518 3.570462 -3.524303 3.475661 Prob. 0.0010 0.0010 0.0010 0.0010 0.0010 0.0010 0.0010 0.0011 0.0012 0.0014 8.524823 0.662019 -1.006246 -0.600748 115.3137 0.000000
76
The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc. Finance and International Business Stefan Zidaru Appendix 3
Commissioner
Entered office[65]
Term expires
Ben Bernanke (Chairman)
February 1, 2006
January 31, 2020 January 31, 2014 (as Chair)
Donald Kohn August 5, 2006 January 31, 2016 (Vice Chairman) June 23, 2006 (as VC) June 22, 2010 (as VC)
Kevin Warsh
February 24, 2006
January 31, 2018
Elizabeth Duke
August 5, 2008
January 31, 2012
Daniel Tarullo
January 28, 2009
January 31, 2022
Vacant
January 31, 2014
Vacant
January 31, 2024
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The European Central Bank: Monetary Policy Instruments, Crisis management and European Macroeconomic performance Msc.

Finance and International Business Stefan Zidaru

1. Introduction 1.1 Problem Statement

2. The European Central Bank and its monetary policy

2.1 Introduction to the European Central Bank

www.ecb.int/ecb/history/emu/html/index.en.html The ECBs monetary policy strategy, www.ecb.int/mopo/intro/html/index.en.html 5 ibid

THE THREE MAIN DECISION MAKING BODIES OF THE ECB

FOUR OTHER MEMBERS OF THE EXECUTIVE BOARD

FOUR OTHER MEMBERS OF THE EXECUTIVE BOARD

GOVERNORS OF THE EURO AREA NATIONAL CENTRAL BANKS

GOVERNORS OF THE NATIONAL CENTRAL BANKS OF ALL EU MEMBERS STATES

The monetary policy of the ECB, ECB 2004 page 54-56

The monetary policy of the ECB, ECB 2004 page 46

BANK AND MARKET INTEREST RATES

CHANGES IN GLOBAL ECONOMY

WAGE AND PRICE-SETTING

SUPPLY AND DEMAND IN GOODS AND LABOUR MARKETS

CHANGES IN FISCAL POLICY

CHANGES IN COMODITY PRICES

ECB INTEREST RATES

ECB website, http://www.ecb.int/paym/t2/html/index.en.html ECB website, http://www.ecb.int/press/pressconf/2000/html/is000608.en.html

Chapter 3. The European banking system

ECB main lending facility rate Chart 4

Eonia interest rate Chart 5

Euribor 12 month interest rate Chart 6 Source: http://www.euribor-rates.eu

Source: ECB annual report 2007 Chart 7

Source: ECB annual report 2007 Chart 11

Chapter 4. Empirical evidence of the usefulness of the monetary policy

www.ecb.eu (http://www.ecb.eu/press/pressconf/2008/html/is081106.en.html) Appendix 1

Figure 4 Thus, the inflation equation is the following:

Inflation rate = 14.83941 4.730308*ECBmain_refinancing_facility + 1.758928*ECB_minimum_reserves_rates - 0.130760*M3t + 2.567140*Eonia_interest_rate - 1.265579*Qunemployment + t

2009Q1 2009Q2 2009Q3 2009Q4 2010Q1

2,880952 1,987903 1,75 1,75 1,75

1,374 0,771565 0,356266 0,35271 0,343048

2,218381 1,67321 1,336939 1,238646 1,22373

0,957143 0,158065 -0,40758 0,432308 1,150794

5,688889 4,151613 2,374242 -0,09692 -0,15

8,814286 9,33 9,66197 9,853385 9,96

-5,03 -4,9021 -4,07 -2,16

Ben Bernanke (Chairman)

January 31, 2020 January 31, 2014 (as Chair)

February 24, 2006

January 31, 2018

January 31, 2012

January 28, 2009

January 31, 2022

January 31, 2014

January 31, 2024

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Inflation rate = 14.83941 4.730308ECBmain_refinancing_facility + 1.758928ECB_minimum_reserves_rates - 0.130760M3t + 2.567140Eonia_interest_rate - 1.265579*Qunemployment + t