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									 Money and Banking
    ECB Report

Annie YuenHee Kim ~ Lillian Neal

 Tia Belisle ~ Adrienne Semann

        Professor Demar

 Econ 322 – Money and Banking

         May 18, 2007


      In consideration of Monetary Policy, we wish to overcome the global imbalances

that are affecting markets in smaller countries such as Italy and Ireland, as well as

global powerhouses such as Spain and Germany. International trade has allowed more

countries to become debtors, taking apart barriers for new investment opportunities.


      Ireland proposes to lower interest rates in order to prevent stagnant or negative
growth in the economy. It is a necessity that the interest rate is lowered because in
order for Ireland to pull through the negative growth stage in the economy. This
expansionary monetary policy will help boost the economy and further benefit the
European Union.


      Italy is suffering from high government taxes imposed upon the people as a

result of the increasing governmental debt incurred. Transaction costs for conducting

business in international markets are high and threaten financial equilibrium. They

support the European Commission‟s proposal of a code of conduct for market

operations. In addressing current interest rates, Italy would like to see an incremental

increase to discourage current debt accumulation.


      Spain is at the top of an economic cycle right now, on the verge of a bust from

its enormous boom.       Two main issues are facing the economy; that of high

unemployment rates and employment wages, and that of an overvalued and

overheated housing market. The central bank of spain, Banco de Spania, proposes to

slightly increase the Federal Funds Rate (interest rates) in order to deter consumer

spending.   Also, raising the Required Reserves Rate would decrease the amount of

excess reserves held by banks, which would prevent more loans to be offered.


       Since Germany had merged between West Germany and East Germany they had

suffered with some issues, however the German economy as it is known is an

outgrowth today. Unemployment rate Germany reported unemployment of 10.6%,

while in Ireland the rate was a mere 4.6%. Germany with the highest unemployment

rate ranked 18th.     As the European's most powerful national central bank, the

Bundesbank played a pivotal role in the planning of and preparation for the euro. One

of its primary roles now is to implement the monetary policies of the European System

of Central Banks to help maintain the euro's stability.


       The National Central Banks control their own budgets and the budget of the

European Central Bank in Frankfurt. The monetary operations are not centralized and

the ECB is not involved in supervision and regulation of financial institutions. These

tasks are left to the individual countries in the European Monetary Union. The

Governing Council meets monthly at the ECB in Frankfurt to make decisions on

monetary policy. The Governing Council operates on a consensus basis. The Maastricht

Treaty states that the overriding long-term goal of the ECB is price stability. The

quantitative goal of the Eurosystem is for monetary policy to be an inflation rate slightly

less than 2 per cent. The ECB uses open market operations, lending to banks and

reserve requirements as monetary policy tools. The primary tool used is open market

operations for conducting monetary policy and setting the overnight cash rate at the

target financing rate.

       As a member of the Eurosystem the primary objective of the Central Bank of

Ireland is the maintenance of price stability in the euro area. Ireland is able to

individually determine their fiscal policy however must jointly determine the monetary

policy with the EU. The Bank‟s investment portfolio is comprised of both foreign

currency and euro-denominated assets. With investments in major money and capital

markets with instruments that include deposits, government bonds and other high-

quality fixed income securities.

       The primary goal of the ECB is price stability however there are five other goals

that need to be considered for individual countries. These goals include high

employment, economic growth, stability of financial markets, interest-rate stability and

stability in foreign exchange markets. The future outlook for Ireland expects a GNP

growth of 4 ¾ per cent and 5 per cent for GDP for 2007. Unemployment is expected to

remain low and inflation seems to remain above the euro area average with a forecast

inflation of 2 ½ per cent. Ireland‟s economy has a high dependence on imported oil and

strong growth domestically which has affected the rate of inflation that drives the

interest rate. As seen in the graph below Ireland‟s economy has gone through its ups

and downs. Currently they are expected to face a continued gradual loss of

competitiveness because inflation is predicted to be higher than the euro area average.

( In 2006 inflation averaged 3.9 per cent which is 1.9 per cent above

the desired goal of the Eurosystem monetary policy.

                         Inflation Rate (GDP Deflator)

































          Currently Ireland is at a different stage of the economic cycle than other

countries such as Germany. Ireland is at the end of a property boom which leads them

to lost competitiveness. With falling housing prices there is considerable risk that prices

will suffer a protracted period of decline. This could lead to a period of stagnant or

negative growth ( Ireland relies heavily on exports of tech-goods to the

US, which causes difficulties with the rising euro. Over the past decade Ireland has

been a good performer however with the EMU membership the economy has been

distorted and has being going through a property bubble. Personal debt per capita has

reached the highest in the developed world at 190pc of GDP. While bank lending grew

30pc last year and housing prices have risen at 16pc a year for the past decade.

          Growth in the Irish economy is weaker than earlier in the decade which implies

that higher inflation will adversely effect competitiveness developments. Energy price

movements have also led to volatile inflation rates. These effects have been caused by

the low interest rates. With the possibility of the property expansion slowing down this

leaves Ireland at an instable point in their economy. This calls for the need to decrease

interest rates in order to avoid a busting economy in Ireland.

      With growing levels of household debt, rapidly rising property prices and a

widening current-account deficit, it is clearly visible that expansionary monetary policy

is necessary to save Ireland‟s economy. Expansionary monetary policy first involves

buying treasury securities. Second the discount rate needs to be lowered. Third the

required reserve ratio needs to be lowered. As the interest rate is lowered this will help

to battle the troubles of higher inflation than the euro area average and keep Ireland

competitive. As seen in the graph below as T-securities are bought the deposits in

banks will increase. Banks will then keep some of these deposits as reserves and

therefore non borrowed reserves will increase. This is a “dynamic O.M.O.” that is meant

to change monetary base and change the Federal Funds Rate.





       The other option that Ireland has is lowering the required reserve ratio. As seen

in the graph below as R decreases then required reserves will decrease and therefore

required demand will decrease.






       As a final decision Ireland proposes to lower interest rates in order to prevent

stagnant or negative growth in the economy. This decision is based off of the fact that

Ireland is going through a stage in its economy that will be negatively effected if

inflation and interest rates continue to be higher than average. A lower interest rate will

help contain rising household debt, rising property prices and the widening current-

account deficit. This type of expansionary monetary policy can only benefit Ireland in

the long run also follows the Eurosystem‟s quantitative goal of low or stable inflation.


                                        At the moment Italy is dealing with the difficulties of being in the Euro zone with

a less than stellar public finance record. They are currently suffering from a large

budget deficit (4.1% of GDP), hefty public debt (109% of GDP), slow growth rate

(1.5%), and increased labor costs (+20%) partially due to competition with other Euro

companies. Examining the Italian bond rates it has become aware that bond yields are

low at around 4.15% partially due to low inflation, and also the low risk because of a

required A- rating for those selling bonds.
   Rate of Government Spending to GDP




                                         30.0%                                                                     Series1




                                        (data provided by economics web institute

                                        As it becomes easier for Italy to sell government bonds they concentrate less on

controlling the national debt currently accumulating. One effect from the continuous

decline of Italy‟s GDP is the income effect. As GDP goes down wealth goes down and

therefore the bond demand goes down while at the same time the bond supply is being

shifted due to decreased demand for bonds. There will be less investment in Italian

companies as a result of the following price increases for Italian bonds and the

increased labor costs. These factors reflect the slow national growth rate.

        i                                          P

   I                                           P*
   I*                                          P


One solution to Italy‟s growing national debt would be to conduct open market

operations. By selling securities and stimulating the money supply that provides wealth

for people to begin investing in profitable endeavors. This would promote growth and

stimulate GDP.

When addressing the rising labor costs in Italy it is important to not consider cutting

labor wages. This creates less domestic demand and may lead to a nation crisis relative

to that which happened in France with the young labor protests in 2006. Rather than

cutting wages perhaps companies should outsource certain jobs, or take advantage of

the increased immigration workforce that would be more receptive to lower wages.

       The government‟s lack of control on national debt is partially due to the

unconfirmed needs and wishes of the European Central bank. As Italy is a smaller

country facing many of the same financial issues as Portugal, they should voice their

economic concerns. The steadily rising taxes that the government is enforcing on the

people does not heed well to the lack of productivity.

       Perhaps if the bond market was more discriminate about the Euro member

bonds, then governmental debt could no longer be hidden. The European central bank

(ECB) arbitrarily accepts all collateral from Euro members leaving investors confused

about the risk associated with each individual country, as well as leaving it to the ECB

to bail out those at risk of default.

       While noting the issues with Italy‟s productivity it is important to examine the

cause. The Bank of Italy‟s governor has released a speech that indicates productivity

declines may be due to an aging population with death outnumbering births every year

since 1993 and no changes foreseen in the future. As more people are leaving the

workforce there is increased unemployment which has the potential as a signal to



    Unemployment rate

























(data provided by economics web institute

                        The central bank of Italy should partake in intermediate targeting where the

ultimate goal is growth rate of the money supply and control of inflation. By targeting

quarterly money base rates they effectively control the supply of money. As growth is a

huge issue in Italy and inflation is generally low, the central bank should set a high

money growth target. These “nominal anchors” are credible commitments by the Italian

Central Bank which send quick signals to the market, creating not only market efficiency

but any errors in judgment will quickly be corrected by the markets.

                        Italy must address the lack of GDP they are currently experiencing by integrating

the IS LM model and examining the effects that an increase of interest rates might have

on the economy. We have seen in the previous section that a problem with bond prices

is their adverse effect on money demand and the continuous decline of interest rates in

the money market. As those interest rates are already low, lowering them even more

might put the economy at risk of recession. We hope to correct this with the increase in

output. By increasing output, interest rates are pushed up and money demanded will

increase as more money is in the hands of the people and more transactions are

conducted. We feel that an incremental increase in interest rates will not put the

economy at risk of inflation.

       i                                              i


  I                                              I*


                                                            Y     Y*

           As there is an increase in output and money demanded there will be an increase

in household consumption as well as investment both important aspects of aggregate

demand. This will cause aggregate demand to increase causing the goods market to

move in simultaneous equilibrium with the money market.

           In conclusion the Italian central bank would like to focus on increasing

productivity while overcoming barriers such as high unemployment, high labor costs,

and a decreasing population. The debt to GDP ratio is too high and debt needs to be

reined in. In order to do this we feel that interest rates need to be incrementally raised

to deter more loans being taken out.


        In the past decade, Spain has become one of the most developed countries,

becoming a so called “Global Economic Powerhouse” (Forbes, 2007).             Consistent

economic growth and constant efforts to ensure competitive economic structures are

the main factors contributing to Spain‟s economic success. The country‟s main goal is

to maintain macroeconomic stability, that was has been realized by steady economic

growth in the last decade, accounting an average of 3.7% expansion per year.

( Spain‟s main industries that have been affected and profited from this

growth    include   Services   (65%),   Agriculture/Fishing   (5.3%),   and   Industrial

Manufacturing, Construction and Property Development (29.7%).

        In order to continue success and economic growth, assessment of the countries

weak points must be addressed. There are two main issues to consider in order to

maintain economic strength; encouraging employee and wage changes and managing

the housing market boom (or soon we could say bust).

        Relatively high inflation rates and wide inflation gaps between Spain and other

countries have made it difficult for Spain to keep up with foreign competition. They

continually must avoid erosion and make up for the difference of inflation rates. Higher

inflation has led to increased employee wages. In most cases, higher wages would

provide incentives to increase production; however, Spain has seen a 0.5% decrease in

productivity levels in the last year.   (Economist)   Spain has also been subject to

substantially high unemployment rates; this could be due to the decrease in productivity

and increase in wages, where employers are unable to afford workers. (OECD) Spain is

at risk for significantly high costs, economically and financially, if policies are not

enacted to reduce the gap between higher wages and lower productivity. Many

economists believe that Spain is in a dangerous point in the “relative-cost cycle”, where

wages are more than double that of other Euro companies.

      The figure below shows Spain‟s cyclical trends from 1980 to 2005, which shows

the classic view of booms and busts within an economy. “A typical stop-go cycle starts

with a localized increase in demand, which in turn leads to higher wages, lost

competitiveness and finally to a protracted downturn”, which is where Spain‟s economy

is headed (Economist). Another factor that could largely affect a downturn in Spain‟s

economy „bust‟ is the housing market.

                         Spain's Economic Cycles from 1980-2005.

      Since 1999, Spain has observed generously low interest rates. Low interest rates

provided new opportunities for investors and consumers, boosting confidence,

consumer spending and development.              Construction and property development

increased dramatically. In 2006, more than 800,000 houses were built; totaling more

than France, Germany and Italy combined. Low interests rates, increased demand for

mortgages, which increased housing market development and demand for houses.

With an increase demand for housing, home prices soared; becoming an enticing

market for investors. „Monkey See, Monkey Do; people tend to flow where they believe

they can make money.

      Housing prices have nearly tripled in the last 5 years. As discussed in class, this

is a classic example of the beginning stages of a Kindleberger Crisis; where high

demand leads to an overheated economy, which can lead to „euphoria‟ and „illusions‟ of

profits, which will eventually lead to an economic collapse. According to the Banco de

Espaňa, “in recent years, house prices were 35% overvalued” (Economist). Housing

prices peaked at approximately 18% growth between 2002 and 2003.

      These two issues concerning employment and the housing market have an

extremely high risk of causing massive adverse affects on Spain‟s economy. Changes

need to be made to avoid these risks as much as possible. In both situations there are

several options that could help solve the issues at hand. In addressing the employment

concerns there are two underlying issues, high employment wages and high

unemployment rates. One option would be to decrease wage requirements. By doing

this, it would help close the gap between high wages and low productivity. However

this could cause even lower productivity levels because employees may feel

unappreciated for the work they‟re doing right now. Causing even more decreased

productivity and the possibility of wage strikes, decreasing national wage rates I

probably not the answer. Another option to address unemployment rates would be to

provide more employment opportunities. High employee wages have made it hard for

some employers to keep adequate staffing, forcing layoffs and closing of job positions.

By increasing employment opportunities, essentially would decrease unemployment


         The second issue, that of an overheated and overvalued housing market, also

has two options. In order to “cool” the market, adjustments of the Federal Funds Rate

(interest rate) or adjustments to the Required Reserve Ration must be made. With

generously low interest rates, more and more loans were taken out in order to finance

home building and property development. As of 2005, 65% of Spanish households own

their homes outright.

         The first option, to cool the housing market, would be Federal Funds Targeting

by increasing the interest rate. This would decrease incentives for borrowing more and

the benefits of owning homes and property outright. Along with the increase, providing

incentives for renting, rather than owning homes, would turn off the demand for home

ownership and turn consumer focus on the idea of renting.         This plan may seem

foolproof; however, with 98% of the mortgages and loans made at variable-interest

rates, this would dramatically increase loan payments, which could also increase

delinquency rates because of the inability for consumers to cover the higher payment




      The second option would be Reserve Targeting by increasing the Required

Reserves Ratio, which would further decrease interest rates. By doing this, banks are

likely to decrease the supply of loans and mortgages, because with an increased

required reserves ratio they will be holding less excess reserves in order provide more

loans. With the further decrease in interest rates caused by a raise of the required

reserves ratio, the problem is still not solved. Lower interest rates will only entice and

encourage more demand for loans and consumer spending, which is exactly the

opposite of what would help solve the employment and housing market issues.

                                       NBR     NBR*
       After weighing the different options in addressing the high employment wages,

high unemployment rates, and an overvalued and overheated housing market, it is

difficult to say what would be the best monetary policy action to take.       One must

consider each factor to be adjusted; including economic incentives dealing with lower

employment wages and opening up new employment opportunities to decrease the

unemployment rate.      Other factors include encouragement for renting rather than

owning homes and property, increasing interest rates to deter loans and consumer

spending, and increasing the required reserves ratio in order to regulate the bank‟s

ability and motivation to loan more money. As a final decision, Spain‟s proposes slightly

raising interest rates and the required reserves ratio.

       By increasing interest rates, slightly, we feel that this will effectively deter

consumer spending and the desire to attain loans and mortgages for the purpose of

housing and property development.          Indeed this will cause mortgage and loan

payments to increase, and possible payment delinquency rate to increase, but the

affects for deterring spending will far exceed delinquency problems.

       Finally, by raising the required reserve ratio banks will have higher required

reserves and less excess reserves. Banks supply loans and consumer support through

excess reserves, with these lower, the supply of money support and loan supply will



      Germany is one of the world's most highly developed market economies. It is the

world's third largest economy in USD exchange-rate terms, and the largest economy in

Europe. Germans describe their economic system as "social market economy". The term

"social" is stressed because West Germans wanted an economy that would not only

help the wealthy but also care for the workers and others who might not prove able to

cope with the strenuous competitive demands of a market economy.

      The German economy is replete with contradictions. It is modern but old-

fashioned. It is immensely powerful but suffers from structural weaknesses. It is subject

to national laws and rules but is so closely tied into the European Union that it is no

longer truly independent. It has a central bank that controls European monetary policy

and has a deepening impact on the global economy but that also insists on making its

decisions mainly on the basis of domestic considerations.

      The German economy as it is known today is an outgrowth of the 1990 merger

between the dominant economy of the Federal Republic of Germany (FRG, or West

Germany) and that of the German Democratic Republic (GDR, or East Germany). The

merger will dominate Germany's economic policy and reality until well into the next

century. The record of the West German economy during the four decades before

unification shows a signal achievement. In the 1980s, new policies at home and a more

stable environment abroad had combined to put West Germany back on the path of

growth. The East German had grown increasingly inefficient, and its currency had

become worthless outside its own borders. The united German economy is a dominant

force in world markets because of the strong export orientation that has been part of

the German tradition for centuries.

       Germany experienced an economic boom immediately after unification. From the

1948 currency reform until the early 1970s, West Germany experienced almost

continuous economic expansion, but real GDP growth slowed and even declined from

the mid-1970s through the recession of the early 1980s. The economy then

experienced eight consecutive years of growth that ended with a downturn beginning in

late 1992. Since reunification in 1990, Germany has seen annual average real growth of

only about 1.5% and stubbornly high unemployment. The best performance since

reunification was registered in 2000, when real growth reached 3.2%.

       Most foreign and German experts consider domestic structural problems to be

mainly responsible for recent sluggish performance. They note that

      an inflexible labour market is a main cause of persistently high unemployment

      the same is true for high non-wage labour costs

      heavy bureaucratic regulations burden many businesses and the process of

       starting new businesses

       Germany reported unemployment of 10.6%, while in Ireland the rate was a mere

4.6%. Germany with the highest unemployment rate ranked 18th.

       Germany finances its reunification to a large extent by social insurance

contributions, forcing up non-wage labour costs. To conserve the competitiveness of

German workers, the unions abandon high wage claims since the mid-1990s (according

to the Federal Statistical Office Germany, the average net income after deduction of

consumer price rises declined by 2% between 1991 and 2005).

       West Germany developed a system of high wages and high social benefits that

has been carried over into united Germany. German labor costs are above those of

most other states, not because of the wages themselves, which are high by global

standards but not out of line with German labor productivity, but because of social

costs, which impose burdens equal to the wages themselves. The Germans have not

solved this problem, but they are beginning to address it more seriously than before.

      The dominant force in the German economy is the banking system. Germany's

central bank, the Deutsche Bundesbank, is headquartered in Frankfurt am Main, which

is the country's main financial centre and also the base of the European Central Bank.

The central bank, the Bundesbank, is deeply committed to maintaining the value of the

nation's currency, the deutsche mark, even at some potential cost to economic growth.

German industrial and service companies rely much more on bank finance than on

equity capital. The banks provide the money and in turn sit on the supervisory boards

of most of Germany's corporations. They stress the traditional banking virtues of slow

but steady and non-risky growth. As the European's most powerful national central

bank, the Bundesbank played a pivotal role in the planning of and preparation for the

euro. One of its primary roles now is to implement the monetary policies of the

European System of Central Banks to help maintain the euro's stability.

      The Bundesbank demonstrated its genuine independence in 1991 when it

insisted that additional government expenditure for the eastern sector be covered by

unwelcome tax increases rather than by borrowing. Individual Land (state) central

banks are the Bundesbank's representatives at state level.

      At the core of Germany's success and influence lies its currency. The deutsche

mark gave concrete expression to West Germany's international financial and economic

success and also contributed to it. Since unification, it has become even more important

as a symbol as well as an instrument of Germany's new central role in Europe. The

success of the deutsche mark has been anchored in the success of West German

exports, in the Bundesbank's solicitous management of the currency's value, and in the

confidence generated by the country's prosperity.


      European bank's first bids for growth by acquisitions would naturally be made

nationally, where mergers are easier in terms of culture and regulation, and they may

also bring local market power. But there will be losers from such increases in market

power, notably small businesses, which will not be big enough to access the new euro

financial markets directly, and consumers, at least until direct banking becomes more


Because national banking market structures and lending practices differ across Europe,

the same change in interest rates will affect Europe countries‟ economies differently.

This could be a serious hindrance to the operation of a single monetary policy.

      Few European banks will make it to the status of universal banks. The outcome

is uncertain. European universal banks will be boosted by the advantage of incumbency

in most of the areas in which they are active. The difficulty of integrating investment

and commercial banking cultures is the biggest challenge for the new European

universal banks.

      The European bank will take into consideration all of the wishes of the individual

countries. Italy would like to see an incremental increase in interest rates to discourage

the increasing rate of borrowing. Spain would also like to see higher interest rates to

deter the increase in consumer spending. However Ireland would like to see rates

decreased due to the current housing market. Likewise Germany would like to see

lower rates to help lower the current inflation and offset high taxes Germans are


      With these inputs carefully considered, it is decided that interest rates will be

incrementally raised because the current high inflation in Germany is not at a

dangerous level, and Ireland will be able to address the housing market with the

increase of competition among buyers.


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