Money and Banking
Annie YuenHee Kim ~ Lillian Neal
Tia Belisle ~ Adrienne Semann
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
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.
(Economist.com) 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 (Economist.com). 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
(data provided by economics web institute www.economicswebinstitute.org)
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.
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
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
(data provided by economics web institute www.economicswebinstitute.org)
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.
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.
(Economist.com) 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.
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
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.