What matters most for Central Banks when Implementing Monetary Policy?

Describe three challenges the ECB faces in the short to medium term, and the Policy instruments they have in place to meet those challenges.

Introduction. Central banks play the biggest roles in the financial structure of their respective countries. They are responsible for issuing the nations currencies; they are the governments bank as they manage public debt, government expenditure and accept tax revenues that are collected by the government. The central banks also act as lenders of last resort that is to say if the commercial banks run short of cash due to excessive demand, the central bank will lend cash to the commercial banks to alleviate the shortage. (Spencer and McCarthy 1992). However, the most apparent responsibility of Central Banks is controlling the amount of money in the economy through their monetary policy. Central banks aim for certain inflation rates in the country, if inflation rates are too high, then there is an increase in prices and a decline in the purchasing power of money (currency devaluation). This is not good because it affects the countrys currency exchange rates with other countries and the country finds it hard to compete with other countries in terms of trade as they are always worse off due to having the weaker currency. If the rates are too low then there is deflation and this happens when government investment or even public spending is too low and therefore there is a shortage of money in the economy and this almost always leads to unemployment and eventually a drop in the Gross Domestic Product (GDP) of the country and eventually a drop in economic growth. The central banks therefore, have to try and have the inflation rate projected and almost maintained at an optimum level to avoid extreme inflation or deflation. Their main focus therefore is price stability and this is influenced by inflation rates. When there is deflation, price instability occurs and this may affect the incentives to invest in that particular economy.

The main focus of this paper, however, is the challenges faced by one of the biggest central banks- The European Central Bank (ECB) and the policy instruments that the ECB has in place to overcome these challenges. There has never been a better time to write about the ECBs challenges than now. In the past 3 or even four years, the ECB has had its biggest test of all time and has struggled and is still struggling to come out of it in one piece without putting its reputation and that of the EU in jeopardy. In the rest of this paper, we will talk about the founding aims of the ECB with the main one being control of Price stability. We will also look at the present financial crisis (which is the ECBs biggest challenge at the moment) and how it has harmed the European Union. We will as well look at the policies that the ECB has put in place to deal with the challenges it is facing.

One of the best achievements of the European Union was the European Monetary Union (EMU). This showed that the European countries were not just united socially but also economically and they would form an economy that would rival that of America and in that each member country had a certain sense of financial security. This all looked good on paper as the member states mainly thought of the benefits of the EMU and not the disadvantages that would come and almost threaten their membership in the EMU. Now that there is a big financial crisis that is nothing less than contagious, certain EU members are beginning to second guess their membership. The ECBs main goal at the time of its set up was price stability It can be argued that the ECB put way too much emphasis on price stability and therefore almost did not see the other problems coming because it did not keep a close eye on the actions of the EUs National Central Banks (NCBs), I mean if it had then more than likely none of most of the financial crisis would be happening. Do not get me wrong, price stability is a very important aspect of any economy as it ensures investors that prices will remain stable and therefore they do not demand an inflation risk premium to compensate them for the risks associated with holding nominal assets and this in turn fosters economic welfare and the more obvious one is that price stability controls inflation.

Challenges being faced by the ECB. (EU Financial Crisis)

When the NCBs of the EMU get in serious trouble, the automatic response and policy that the ECB has in place is to refinance these banks in order to prevent the problem form escalating and becoming a sort of epidemic in the whole Euro area. The ECB provides whatever amount of liquidity that is needed to put the banks back into a smooth operating banking system. (Nello 2009) The ECB also influences the interest rates in the short term money markets in order to match them with those of the NCBs. For example when the economic recession was at its peak in 2010, the ECB cut all interest rates to a record low of 1% in order to encourage borrowing and investment in the economy. The ECB in the apparent debt crisis is faced by the big problem of sovereign debts, Greece being the main culprit in this and in order to solve the sovereign debt crisis, the ECB took one of its first steps by forming an agreement to secure Greeces decline of debt to a level equivalent to 120 per cent GDP by 2020.

..This reduction will be partially achieved via voluntary bond exchange involving a 50% nominal discount on notional Greek debt held by private investors and .Euro members will also contribute up to 30 billion euro to the PSI package( Speech by Jos Manuel Gonzlez-Pramo, Member of the ECB executive board, Madrid , November 2011) On top of the Greek debt reduction a new EU- IMF multiannual strategy that would finance up to 100 billion euro is to be put in place by the end of this year. These policies are great but they are bound to create loathing amongst the EU member states, think of it this way, the Irish tax payer is paying a certain amount of tax, a percentage of which is going to bail out Greece, this is a big load on the shoulder for the government seeing as Irish economy isnt doing so great either and then what we have is Ireland being dragged down the same road which by the way

is happening as we speak and so is Portugal, Italy and Spain. So what is next for the European Economy? The ECB could default all the debt, well, the biggest debts but the problem with defaulting is that the investors may lose their trust in the borrower and this may worsen the problem as lack of investment is lack of economic activity which clearly leads to another recession. However, seeing as the Euro system is a huge financial institution maybe the investors might be able to trust it again and invest again once the economy picks up. The problem is that defaulting may be assumed as taking the easy way out even though it is more complicated than it actually comes across. In his recent speech about going towards a safer financial system in Frankfurt , Jrgen Stark , a member of the ECB executive board , made some very interesting points. He pointed out that the Euro zone is in this crisis because of a number of mainly reckless fiscal policies by the governments of the Euro zone. I think this is very true because there is no other proper reason for the financial crisis at the moment .The governments got complacent, they failed to look at the future of the economies and if they relied too much on borrowing and probably left their fate in the hands of the EMU without thinking that things would get way out of hand and they would face the consequences they are facing now . For example in Greece, retirement age prior to the financial crisis was as early as 55 years for men and 50 years for women.. A person at 50 in my opinion is as productive as a person of 45 years and it makes no sense that a country with life expectancy of 80 years would have a retirement age of 60. Of course governments were not the only ones to blame for the current financial crisis, The ECB has a great part in it as well. In referring to solutions to the problems facing the euro system of banks, Jrgen Stark proposed the following solutions that are going to be reinforced by the ECB. The first is the strengthening of the quality and quantity of bank capital, and a harmonisation of the calculation of regulatory capital across jurisdictions. Better and higher bank capital is needed in order to foster the loss-absorbing capacity of banks. To this aim, Basel III increased the minimum common equity Tier 1 (CET1) ratio from 2% to 4.5% of risk weighted assets.

The second is the requirement for banks to build-up buffers above the required minimum, particularly when the economy is booming, thereby providing for additional cushions to absorb losses in periods of financial distress. [2] In addition, further buffer requirements are foreseen for systemically important financial institutions (SIFIs) as well. The third element is directed to enhance the risk coverage of the regulatory framework, providing a more comprehensive treatment of banks exposures to complex financial products whose risk to the system has been neglected so far. The fourth element is the adoption of a simple and transparent rule to prevent the excessive reliance on debt by the banking sector. And last, but not least, the new framework intends to improve banks resilience to liquidity shocks and to increase market confidence in the liquidity position of banks. The intended improvements in the liquidity position of banks aim at containing the excessive reliance on short-term funding and give incentives to hold safe and liquid assets. (Stark, 2011)

Conclusion. Every Central bank dreads budget deficits and this is perfectly understandable because not only do deficits often result in an easy-fiscal tight money policy mix that makes central bankers lives hard and politically unpleasant, but escalating debts which end up in monetisation and inflation portray the ultimate nightmare. (Bainbridge and Whyman 2003).This is evident in the current economic crisis with Greece, Italy, Portugal and Ireland having soaring budget deficits and the ECB trying to put in place certain policies to get them back to normal economic behaviour While Price stability is a very important factor in any economy, but it is not the be all end all, the ECB has realised that after the challenges it has had to face in the last few years. The NCBs need constant

monitoring and while that is one of the tasks of the ECB, the current situation proves that the ECB did not monitor the actions of the NCBs as well as it should have. When the ECB is implementing certain instruments it has to take into account timing, target and the fact that these decisions have to be temporary. Proper timing means that the solution has to be made just in time to deal with whatever challenge the ECB is facing. Targeting means that the ECB has to target its policy specifically to the problematic area in order to avoid confusion or to simply fasten the solution of the problem or challenge and the solution should only go on for a specific short time in order to avoid the banks solely depending on the ECB and therefore they can then make their own solutions to the problems in the future. The future of the European Union is quite unpredictable at the moment and I personally think that it all depends on whether the European Central bank overcomes the current challenges that it is facing and whether or not the member states and other countries can still trust it. The current crisis has also led to price instability in the euro zone as some inflation rates have soared and other countries have faced deflation and eventually suffered unemployment. Bibliography Baimbridge, M.and Whyman, P .(2003) Economic and Monetary Union in Europe. Cheltenham: Edward and Elgar Publishing Limited. Nello. S. (2009) .The European Union: Economics, Policies and History. London: McGrawHill Education McCarthy, D and Spencer K. (2004) Modern Economics. Dublin: Mentor Books. Watson, A. (1997) Aspects of European Monetary Integration: The Politics of Convergence Hampshire: London Stark, J. (2011). Towards a Safer Financial System. Frankfurt. Available: http://www.ecb.int/press/key/date/2011/html/sp111109.en.html. (Accessed 10/11/2011)