The European Central Bank

Tui Euioiiax
Cixriai Baxx
Ciiii ni i i r\, Tiaxs iaiixc\
axi Cixriai i zari ox
Jakob de Haan, Sylvester C.W.
Eijfnger, and Sandra Waller
The adoption of the euro in 1999 by 11 member
states of the European Union created a single currency
area second in economic size only to the United States.
The euro areas monetary policy is now set by the
European Central Bank (ECB) and its Governing
Council rather than by individual national central
banks. This CESifo volume examines issues that have
arisen in the rst years of ECB monetary policy and
analyzes the effect that current ECB policy strategy
and structures may have in the future.
After a detailed description and assessment of
ECB monetary policy making that focuses on such
issues as price stability and the predictability of policy
decisions, the book turns to two important issues
faced by European central bankers: the transparency
and credibility of decision making and the ECBs
decentralized structure. After showing that
transparency in decision making enhances credibility,
the book discusses the ECBs efforts at openness, its
political independence as guaranteed by law, and its
ultimate accountability. The book then considers the
effects of the decentralized ECB structure, focusing on
business cycle synchronization, ination differentials,
and differences in monetary policy transmission in
light of the enlargement of the monetary union. The
book also discusses options for ECB institutional
reforms, including centralization, vote weighting, and
cross-border regional banks.
Jakob de Haan is Professor of Political Economy and
Scientic Director of the research school SOM at the
University of Groningen. Sylvester C. W. Eijfnger is
Professor of Financial Economics at the Center for
Economic Research and the Department of Economics
and Jean Monnet Professor of European Financial and
Monetary Integration at Tilburg University. Sandra
Waller works at Bavarian Landesbank, a state-owned
private institute.
CESifo Book Series
The MIT Press
Massachusetts Institute of Technology
Cambridge, Massachusetts 02142
http://mitpress.mit.edu
Tui Euioiiax
Cixriai Baxx
Ciiii ni i i r\, Tiaxs iaiixc\,
axi Cixriai i zari ox
The authors succeed marvelously in providing the dosage of institutional and theoretical analysis
necessary to understand the functioning of the ECB. As a result this book will be a must not only
for ECB watchers but also for students interested in European affairs.
Paul De Grauwe, Catholic University of Leuven, Belgium
This is a well-researched, carefully written, and nicely balanced study of the monetary policy
mechanisms of the European Central Bank, focusing on the political economy aspects of its
decision-making processes. Besides giving a detailed and generally favourable study of the status
quo, the authors advocate a more complete and overt shift towards an ination targeting strategy, a
continuing focus on transparency and accountability, and greater centralisation of decision making,
especially after the accession countries join the eurozone.
Charles Goodhart, Financial Markets Group, London School of Economics and Political Science
,!7IA2G2-aeccga!:t;K;k;K;k
0-262-04226-6
Jakob de Haan, Sylvester C.W. Eijfnger,
and Sandra Waller
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Continued on back ap
The European Central Bank 3/17/05 2:05 PM Page 1
The European Central
Bank
CESifo Book Series
edited by Hans-Werner Sinn
Marc Gradstein, Moshe Justman, and Volker Meier
The Political Economy of Education: Implications for Growth and Inequality
Assaf Razin and Efraim Sadka, in cooperation with Chang Woon Nam
The Decline of the Welfare State: Demographics and Globalization
Jakob de Haan, Sylvester C. W. Eijfnger, and Sandra Waller
The European Central Bank: Credibility, Transparency, and Centralization
Bank
Credibility, Transparency,
and Centralization
Jakob de Haan,
Sylvester C. W. Eijfnger, and
Sandra Waller
The MIT Press
Cambridge, Massachusetts
London, England
2005 Massachusetts Institute of Technology
All rights reserved. No part of this book may be reproduced in any form by any elec-
tronic or mechanical means (including photocopying, recording, or information storage
and retrieval) without permission in writing from the publisher.
MIT Press books may be purchased at special quantity discounts for business or sales
promotional use. For information, please email special_sales@mitpress.mit.edu or write
to Special Sales Department, The MIT Press, 5 Cambridge Center, Cambridge, MA02142.
This book was set in Palatino by SNP Best-set Typesetter Ltd., Hong Kong and was
printed and bound in the United States of America.
Library of Congress Cataloging-in-Publication Data
Haan, Jakob de.
The European Central Bank: credibility, transparency, and centralization / Jakob de
Haan, Sylvester C. W. Eijfnger, and Sandra Waller.
p. cm. (CESifo book series)
Includes bibliographical references and index.
ISBN 0-262-04226-6 (alk. paper)
1. European Central Bank. 2. Banks and banking, CentralEuropean Union countries.
3. Monetary policyEuropean Union countries. I. Eijfnger, Sylvester C. W. II. Waller,
Sandra. III. Title. IV. Series.
HG2976.H325 2005
332.11094dc22
2004059701
10 9 8 7 6 5 4 3 2 1
Contents
Series Foreword vii
Preface ix
1 Introduction 1
1.1 The Start of the Monetary Union 1
1.2 Main Issues 2
2 The ECB: Structure, Strategy, and Policy 9
2.1 Introduction 9
2.2 Structure of the E(S)CB 10
2.3 Monetary Policy Strategy of the ECB 11
2.4 Monetary Policy of the ECB 16
2.5 ECBs Evaluation of Its Monetary Policy Strategy 21
2.6 Conclusions 25
3 The ECBs Strategy: An Assessment 27
3.1 Introduction 27
3.2 Predictability of Policy Decisions 27
3.3 Ination Objective 36
3.4 Role of the First Pillar 47
3.5 Ination Forecasts 56
3.6 External Value of the Euro 57
3.7 Asset Price Ination 74
3.8 Interest Stepping versus Smoothing 78
3.9 Conclusions 80
4 Transparency, Accountability, and Credibility of the ECB 83
4.1 Introduction 83
4.2 Transparency and Disclosure: Theory and Evidence 85
vi Contents
4.3 Transparency of the ECB 94
4.4 Accountability of the ECB 108
4.5 Blinders Survey on Credibility 112
4.6 Credibility of the ECB 117
4.7 Conclusions 123
5 Centralization or Decentralization 125
5.1 Introduction 125
5.2 The Decentralized Eurosystem 125
5.3 Risks of Decentralization 130
5.4 Diverging Business Cycles in the Euro Area? 137
5.5 Different Ination Rates in the Euro Area 148
5.6 Differences in Monetary Policy Transmission and Financial
Structure 160
5.7 Conclusions 167
6 New Member Countries 169
6.2 Central Bank Independence and Convergence 170
6.3 Implications of Enlargement of the Monetary Union 192
6.4 Conclusions 210
7 Options for Reform 213
7.2 Options for Reform 215
7.3 The ECB Proposal 220
7.4 Conclusions 223
8 Conclusions 225
Notes 229
References 239
Index 261
CESifo Book Series
Foreword
This volume is part of the CESifo Book Series. Each book in the series
aims to cover a topical policy issue in economics. The monographs
reect the research agenda of the Ifo Institute for Economic Research
and they are typically tandem projects where internationally
renowned economists from the CESifo network cooperate with Ifo
researchers. The monographs have been anonymously refereed and
revised after being presented and discussed at several workshops
hosted by the Ifo Institute.
Hans-Werner Sinn
Preface
This book offers our syntheses of the debate on the European Central
Bank (ECB), focusing on two sets of issues: the transparency and cred-
ibility of the ECB, and its decentralized setup. We argue that these
issues are relevant for evaluating the performance of the ECB since
1999. These issues play an important role in the discussion of the ECBs
monetary policy strategy and debate on institutional reform of the ECB.
Parts of this book were presented at seminars and workshops at
various places, including the Bank of England (London), CESifo
(Munich), the ECB (Frankfurt), the University of Antwerp, the Center
for European Studies at Harvard University, and the Bundesbank
(Frankfurt). We would like to thank the participants in these seminars
and workshops for their stimulating comments. Thanks are also due to
Lex Hoogduin, Julius Horvath, and Jan-Egbert Sturm for their com-
ments. We also would like to thank three anonymous referees for their
very helpful suggestions.
We also would like to express our gratitude to a number of our co-
authors of papers that have, in one way or another, found a place in
this book: Ivo Arnold, Helge Berger, Adam Elbourne, Petra Geraats,
Robert Inklaar, Bas Kiviet, Linda Toolsema, Jan-Egbert Sturm, and
Peter van Els. Special thanks are further in order to Maaike Beugels-
dijk, Carin van der Cruijsen, David-Jan Janssen, Olaf de Groot, Richard
Jong-a-Pin, Robert Inklaar, and Jrg Reddig for their assistance in gath-
ering data and other research assistance. Last we would like to thank
the Nederlandsche Bank for providing valuable data and Dana Andrus
for editorial support.
Bank
1.1 The Start of the Monetary Union
On January 1, 1999, Europe entered a new era with the adoption of a
single currencythe euroby eleven of the fteen member states of
the European Union (EU). Greece joined the euro area in 2001. For the
rst time since the Roman empire a large portion of Europe now shares
a common currency.
1
The launch of the euro has created the worlds
second largest single currency area in terms of economic size after the
Unites States.
It is the rst time in history that countries of anything like this
number, size, or global economic weight have gathered together on a
voluntary basis to share a currency and pool their monetary sover-
eignty. With the start of the nal phase of the Economic and Monetary
Union (EMU), participating countries no longer have their own mon-
etary sovereignty. Monetary policy in the euro area has been delegated
to the European Central Bank (ECB). The Governing Council of the
ECB is responsible for taking monetary policy decisions. This Council
consists of the Executive Board of the ECBmade up of the president,
the vice president, and four other membersand the central bank gov-
ernors from the twelve euro countries. Together with national central
banks, the ECB is part of the European System of Central Banks (ESCB).
While the ECB is responsible for policy decisions, national central
banks play a role in implementing monetary policy.
2
The ECBs primary objective, as laid down in the Maastricht
Treaty, is price stability. In 1998 the ECB announced its interpretation
of price stability: maintaining ination below 2 percent in the medium
term. It also developed a so-called two-pillar strategy to accomplish
this objective. The instruments and procedures through which the
Eurosystemnamely the ECB and the national central banks in the
1
Introduction
2 Introduction
euro area
3
conducts its operations are working smoothly. Financial
operators learned to cope with the new money market in just a few
weeks.
Not so long ago, the idea of merging the monetary systems of the
EU countries seemed fantastic. Nevertheless, a plan for doing so was
drawn up by the Delors Committee. This committeenamed after its
chairman, Jacques Delors, who was at the time the president of the
European Commissionwas authorized by the European Council in
June 1988 with the task of studying and proposing stages leading to
economic and monetary union. Its report proposed three stages in a
gradual move to monetary union, but stressed that the timing of each
stage required a political decision. Many ideas of the Delors Commit-
tee found their way in the Maastricht Treaty, named after the place in
the Netherlands where the leaders of the EU countries met to take a
decision on EMU.
Then, with the ink of this blueprint barely dry, the forerunner of the
single currency, the Exchange Rate Mechanism (ERM) of the European
Monetary System (EMS), almost collapsed, casting doubt about the
project. Many skeptics asked what hope there could be for a monetary
union among countries unable to keep national currencies aligned.
4
Indeed, sometimes EMU was perceived as an ambitious project that
would never y, just like the emu, the large Australian bird. Still the
European governments carried on. With the start of the monetary
union in January 1999 their vision became reality.
1.2 Main Issues
With the 1999 start of the monetary union, the ECB became respon-
sible for monetary policy making.
5
Chapter 2 describes the ECBs
monetary policy strategy and policy decisions in some detail. The
monetary policy strategy of the ECB, which was announced on October
13, 1998, consists of three main elements: a quantitative denition of
price stability, a prominent role for money in the assessment of risks
to price stability (at the time called the rst pillar), and a broadly
based assessment of the outlook for price developments (the second
pillar). In accord with the rst pillar, the ECB uses a quantitative ref-
erence value for the annual growth rate of a broad monetary aggregate
(M3) by which it can assess whether monetary developments pose a
risk to price stability. The denition of price stability adopted was a
year-on-year increase of the Harmonized Index of Consumer Prices
(HICP) for the euro area, which was not to exceed 2 percent in the
medium term.
In December 2002 the ECB Governing Council decided to evaluate
the strategy, taking into account the public debate and the outcomes of
research undertaken by staff of the Eurosystem. The results of this eval-
uation were published in May 2003. The Governing Council agreed
that in the pursuit of price stability, it would aim to maintain ination
rates below but close to 2 percent over the medium term. According
to the Council, this clarication underlines the ECBs commitment to
provide a sufcient safety margin to guard against the risks of dea-
tion. It also addresses the issue of the possible presence of a measure-
ment bias in the HICP and the implications of ination differentials
within the euro area. The Council also decided that in the presenta-
tion of the arguments for a certain policy decision, the president of the
ECB would start with what is now called the Economic Analysis (i.e.,
the previous second pillar). Most academic observers considered these
decisions to imply that the rst pillar had become less important.
Although they were generally argued to be in the right direction, many
such observers claimed that the steps taken by the Governing Council
did not go far enough. Svensson (2003) stated, for instance, that It
would have been better to throw the reference value on the garbage
heap of history where it belongs.
Chapter 3 offers our assessment of the ECBs monetary policy
strategy. We focus on issues like the denition of price stability, the
predictability of policy decisions, and the role of the rst pillar. In
this chapter we also discuss the role of the external value of the euro
in the ECBs strategy.
The rest of the book deals with two sets of issues that European central
bankers are faced with. Arst important issue for the ECBas it is for
every central bankis its transparency. According to the Code of Good
Practices on Transparency in Monetary and Financial Policies of the
International Monetary Fund (IMF 2000a)
6
:
The case for transparency of monetary and nancial policies is based on two
main premises. First, the effectiveness of monetary and nancial policies can
be strengthened if the goals and instruments of policy are known to the public
and if the authorities can make a credible commitment to meeting them. In
making available more information about monetary and nancial policies,
good transparency practices promote the potential efciency of markets.
Second, good governance calls for central banks and nancial agencies to be
Introduction 3
4 Introduction
accountable; particularly where the monetary and nancial authorities are
granted a high degree of autonomy. . . . In making the objectives of monetary
policy public, the central bank enhances the publics understanding of what it
is seeking to achieve, and provides a context for articulating its own policy
choices, thereby contributing to the effectiveness of monetary policy. Further,
by providing the private sector with a clear description of the considerations
guiding monetary policy decisions, transparency about the policy process
makes the monetary policy transmission mechanism generally more effective,
in part by ensuring that market expectations can be formed more efciently.
By providing the public with adequate information about its activities, the
central bank can establish a mechanism for strengthening its credibility by
matching its actions to its public statements.
The ECB tries to be open. There are, for instance, regular press con-
ferences, a monthly bulletin is being issued and the president of the
ECB appears before the European Parliament four times each year.
Recently the ECB also started to publish staff forecasts (i.e., projections)
of ination. All this has led Otmar Issingmember of the Executive
Board and chief economist of the ECBto conclude that in terms of
transparency, the ECB can emerge proudly from the comparison to any
other leading central bank (Issing 2001a, p. 14). However, nancial
market reports often suggest that the ECB has not been very success-
ful in explaining its policies to nancial market participants. For
instance, in the Goldman Sachs Weekly Analyst of June 25, 1999, it
was stated that the ECB has not yet succeeded in giving an entirely
clear and convincing message on monetary policy issues to nancial
markets. In chapter 4 we analyze the transparency of the ECB.
As follows from the citation of the IMF Code of Good Practices on
Transparency, it is often argued that transparency may enhance the
credibility of the policy maker. Although economists often base their
models on the notion of credibility, little is actually known about it. For
instance, how can a central bank become credible? Should a central
bank be independent to be credible? In a survey among central bankers,
Blinder (2000) asked his respondents how important credibility is. It
appeared that there is a broad consensus among central bankers that
credibility is very important. Blinder also asked his respondents how
a central bank can build credibility. On a scale from 1 (unimportant) to
5 (of the utmost importance) the answer granting a central bank inde-
pendence received an average score of 4.51, becoming the second
highest score after a history of honesty (4.58). Do nancial market
participants agree with central bankers that credibility is important?
And if so, why, and how can it be built? And how is the ECB rated in
terms of credibility in comparison to, for instance, the US Federal
Reserve and the Bank of England? Chapter 4 reports the outcomes of
a survey similar to Blinders among private sector economists on the
credibility of the ECB.
The ECB isat least in legal termspolitically independent. Not
only does the Maastricht Treaty prohibit the ECB from taking orders
from politicians, the members of the Executive Board are appointed for
eight-year, nonrenewable terms, insulating them from pressures to
please politicians in order to get re-appointed. National central bank
governors have, at minimum, ve-year contracts. As follows from the
citation of the IMF Code on Good Practice on Transparency, indepen-
dent agencies should be accountable. The nal issue in chapter 4 is
therefore the accountability of the ECB.
The second main issue on which the book focuses is the decentralized
structure of the central bank of the euro area. As will be explained in
more detail in chapter 2, in the initial setup of the ECB presidents of
national central banks have a majority in the Governing Council. This
is unlike the US central bank structure, with just 5 members from the
regional Federal Reserve Banks within the decision-making Federal
Open Market Committee of 12 members. Also in comparison with the
German Bundesbankwith 9 votes from the Land central banks within
the Bundesbanks Central Bank Council of 17 membersthe ECB is
very decentralized. Critics of the ESCB sometimes argue that its decen-
tralization is a design aw. For instance, The Economist stated that:
The Governing Council is supposed to set interest rates according to conditions
in the euro area as a whole, but there is a risk that national governors will be
unduly inuenced by conditions in their home country. Small countries may
also carry undue weight in the system. . . . A weak centre, combined with
strong national interests, could create conicts that undermine the whole
systems credibility.
7
There are at least three conditions that must be met for a common mon-
etary policy to succeed without causing frictions among the members
of the monetary union (Guiso et al. 1999). First, members must agree
on the ultimate goals of the common monetary policy. This issue was
largely settled through the Maastricht Treaty and the ensuing ratica-
tion process, leading to the adoption of price stability as the primary
objective for the ECB. Second, the common monetary policy will be
easier to implement if the member countries business cycles are
Introduction 5
6 Introduction
aligned and if ination rates are very similar. If various countries (or
sizable regions) in the monetary union are not at the same points in the
business cycle or have different ination rates, decision making on the
appropriate monetary policy stance becomes a difcult task. It is clear
that countries in the euro area sometimes have different ination rates
and business cycles, although some authors have argued that mone-
tary and economic integration will lead to more business cycle syn-
chronization (e.g., see Frankel and Rose 1998). Third, the monetary
policy transmission mechanism should operate in a similar fashion
across the member countries of the monetary union. Differences in the
transmission mechanism could mean that the appropriate size and
timing of monetary policy decisions are difcult to assess. Moreover, if
the burden of adjustment is not equally shared across countries, sizable
distribution differences may create political tensions. Chapter 5 deals
with these issues. In particular, in this chapter we examine the degree
of business cycle synchronization in the euro area, the ination differ-
entials among the euro countries, and (the persistence of) differences
in monetary transmission across these countries.
Although the ECB is a very young institution, there is already a
debate going on about its reform in view of the recent enlargement
of the European Union. The new EU members (eight eastern European
countries and two southern European countries) are expected to apply
soon for euro area membership. Negotiations about EU membership
started with Poland, Hungary, the Czech Republic, Slovenia, Estonia,
and Cyprus in March 1998; in February 2000 negotiations were opened
with Slovakia, Malta, Bulgaria, Romania, Latvia, and Lithuania.
8
The European Union has outlined a three-step approach to the mon-
etary integration of the accession countries. The applicants must rst
join the European Union, next enter the Exchange Rate Mechanism II
(ERM II), and, nally, after fulllment of the Maastricht convergence
criteria, accede to the euro area.
To qualify for EU membership, an applicant must have a strong
market economy and stable institutions that guarantee democracy, the
rule of law, and human rights. Furthermore the country must have
largely adapted its laws to comply with EU legislation, known as the
acquis communautaire, and have the ability to implement that legisla-
tion. In December 2002 the European Union decided that all applicant
countries, except for Bulgaria and Romania, could become EU
members in 2004. Bulgaria and Romania will enter at a later stage.
At some point in time, the new EU members will join the euro area
(chapter 6). Furthermore in the near future three EU members that
are currently not members of the euro area might adopt the euro (the
United Kingdom, Sweden, and Denmark). So membership in the
Eurosystem could increase from the current 12 to 27. In the absence
of modication of the current ECB statute, this enlargement could
have severe consequences for the efciency of monetary policy making
in the euro area. A larger ECB Council would experience great dif-
culties in decision making. Without reform of the current ECB Statute,
the size of the ECB Governing Council could increase from 18 to 33,
making it by far the largest monetary policy-making institution among
OECD countries. Due to this increase in membership, discussion
and voting procedures will likely become more time-consuming and
complicated.
A second reason why the issue of reform of the ECB is on the polit-
ical agenda is related to the decentralized nature of the ECB.
9
Since
almost all accession countries are small in economic terms relative to
current euro area members, enlargement within the given institutional
setup will signicantly increase the degree of overrepresentation of the
areas smaller member countries in the Council in terms of relative eco-
nomic size. For instance, in a monetary union with 27 members the
current ECB statute implies that the representatives of its smallest 17
member states, representing only about 10 percent of the areas aggre-
gated GDP, could determine monetary policy decisions in the euro
area. Overrepresentation, while not necessarily a problem per se, has
the potential to introduce an unwelcome bias into the ECBs decision
making, if country representatives put at least some weight on national
economic developments and these developments deviated notably
from the behavior of euro area aggregates. Since the bulk of the acces-
sion countries are transition economies, they may be subject to idio-
syncratic shocks and somewhat higher structural ination than the core
of the euro area. Chapter 6 therefore discusses business cycle synchro-
nization, ination differentials, and monetary policy transmission in
the accession countries.
There are various ways how the ECB can be reformed, like central-
ization (the Executive Board will become responsible for policy deci-
sions), vote weighting (the vote of a national central banker depends
on the size of the economy), representation (one central banker repre-
sents various central banks), extending regional central banks across
Introduction 7
8 Introduction
national borders, and rotation (the governors of national central banks
have rotating voting rights). The ECB has chosen for a system of
rotation, in which national central banks have rotating voting rights,
depending on the size of their economies. Many academics have criti-
cized the ECB proposal and favor more centralization. Chapter 7 there-
fore presents various options for reform of the ECB. The nal chapter
of the book offers our main conclusions.
2.1 Introduction
The Maastricht Treaty made the European Central Bank (ECB) politi-
cally independent. Nowadays it is widely believed that central bank
independence and an explicit mandate for the bank to restrain ina-
tion are important institutional devices to ensure price stability. It is
thought that an independent central bank can give full priority to main-
taining low levels of ination. In countries with dependent central
banks other considerations (notably, re-election prospects of politicians
and low levels of unemployment) can interfere with the objective of
price stability. The example often mentioned is the German central
bank. Because the Deutsche Bundesbank was relatively autonomous,
Germany had one of the best postSecond World War ination records
among the OECD countries. The statute of the ECB is largely modeled
after the laws governing the Bundesbank.
This chapter starts with a brief description of the structure of the
European System of Central Banks (ESCB) (section 2.2), followed by a
discussion of the monetary policy strategy of the ECB (section 2.3) and
actual policies since 1999 (section 2.4).
1
The monetary policy strategy
of the ECB has three main elements: a quantitative denition of price
stability, a prominent role for money in the assessment of risks to price
stability, and a broadly based assessment of the outlook for price devel-
opments. In December 2002 the ECB Governing Council decided to
evaluate this strategy in the light of the experience, taking into account
the public debate and the outcomes of research undertaken by staff of
the Eurosystem. The results of this evaluation were published in May
2003. Section 2.5 discusses the results, while the nal section offers our
conclusions.
2
The ECB: Structure,
Strategy, and Policy
10 Chapter 2
2.2 Structure of the E(S)CB
The European System of Central Banks consists of the European Central
Bank and the national central banks. The ECB and the national central
banks of the countries that have adopted the euro are often referred to
as the Eurosystem. If all member states of the EU adopt the euro, the
Eurosystem and ESCB will be synonymous.
The ESCB is governed by the decision-making bodies of the ECB: the
Governing Council, the Executive Board, and the General Council
(see gure 2.1). The Governing Council of the ECB is the most important
decision-making body of the ECB. It consists of the Executive Board of
the ECB and the governors of the national central banks of the coun-
tries in the euro area. The Governing Council is responsible for for-
mulating monetary policy, including decisions about intermediate
objectives and interest rates. The Council decides, in principle, by
simple majority. At the time of writing, 12 out of the 18 members in the
Governing Council are presidents of national central banks, who have
been appointed by their respective governments. However, when
taking monetary policy decisions, the members of the Governing
Council of the ECB are not expected to act as national representatives
but rather in a fully independent personal capacity. The setup of the
ECB is therefore based on the principle of one person, one vote. This
way national central bankers are involved in monetary policy deci-
Figure 2.1
Structure of the European System of Central Banks. (Source: Eijfnger and De Haan 2000)
ESCB
15 National central banks: 3 outs and 12 ins:
ECB
Governing Council Executive Board General Council
President President Executive Board of the ECB
Vice president Vice president and
Governors of the central banks of the
Up to four other members Governors of
countries in the euro area
national central
banks
Eurosystem
sions, and in this respect the ECB differs from other central banks in
federal countries (see chapter 5 for a further discussion). In looking
ahead to the enlargement of the monetary union (see chapter 6),
various proposals were put forward to reform the ECB. These reform
proposals are discussed in chapter 7.
The Executive Board of the ECB consists of the president, the vice
president, and up to four other members. The Executive Board imple-
ments monetary policy decisions taken by the Governing Council. In
doing so, it may give instructions to national central banks. The Euro-
pean Council appoints members of the Executive Board. Their term in
ofce is eight years and is not renewable. A system of staggered
appointments has been applied for the appointment of its rst
members.
As long as not all EU member states use the euro as their currency,
the General Council will also play a role within the ESCB. It consists of
the president and vice president of the ECB and the governors of the
national central banks of all EU member countries. As the central banks
of the EU countries that have not (yet) adopted the euro continue to
pursue national monetary policies, they will not participate in deci-
sions related to the single monetary policy for the euro area. In the
General Council they will, however, have the opportunity to discuss
monetary policy issues and their exchange rate relations with the euro.
2.3 Monetary Policy Strategy of the ECB
The primary objective of the ESCB is price stability.
2
However, the
Maastricht Treaty does not provide a specic denition of this objec-
tive. In October 1998 the Governing Council of the ECB dened price
stability as follows: a year-on-year increase of the Harmonized Index of
Consumer Prices (HICP) for the euro area, which does not exceed 2
percent in the medium term. Issing et al. (2001) point out that this quan-
tication is in agreement with the stated preferences of European gov-
ernments as expressed several times in the European Councils Broad
Economic Guidelines.
The HICP is a comprehensive measure for ination, reecting the
focus of the general public on consumer goods.
3
The aim of an ina-
tion rate below 2 percent clearly delineates the maximum rate of
ination deemed to be consistent with price stability. The wording
year-on-year increases implies that persistent price decreases
that is to say, deation in the measured price indexwould not be
The ECB: Structure, Strategy, and Policy 11
12 Chapter 2
considered to be consistent with price stability either. The Governing
Council explicitly announced that price stability is to be maintained
over the medium term, thereby acknowledging that price levels may
be temporarily distorted by short-term factors. As Issing (2001a, p. 10)
states:
[T]he track record of the ECB . . . cannot be assessed on the basis of temporary
deviations from price stability caused by external and unavoidable shocks. In
view of the lags with which monetary policy affects the economy, a central bank
cannot ensure price stability at each and every moment in time in the face of
exogenous shocks.
The wording for the euro area highlights that areawide develop-
ments, instead of specic national or regional factors, are the only
determinants of decisions regarding the single monetary policy. Ayear-
on-year increase of the HICP for the euro area as a whole represents
price stability, even if increases in national price indexes are above 2
percent per year. As Issing (2001a, p. 8) puts it:
[R]egional ination differentials [should] not be considered as a necessary
source of problems . . . the differentials may be reecting the appropriate eco-
nomic adjustment to the temporary insurgence of disparities in productivity
growth or to the realization of other asymmetric shocks.
At the time the monetary policy of the ECB was introduced, it rested on
the strategy of two pillars (ECB 2004). The rst pillar is a prominent role
for money. As ination in the long run is considered to be a monetary
phenomenon, the ECB Governing Council announced a quantitative
reference value for the annual growth rate of a broad monetary aggre-
gate (M3). The focus on M3 was supported, according to the ECB
(2001), by its favorable empirical properties such as a stable money
demand function. Furthermore M3 is known to be a good indicator of
ination (Issing et al. 2001). A reference value for M3 growth was set
at 4.5 percent but was not considered intermediate monetary target, in
order to avoid an automatic monetary policy reaction to uctuations
in M3 growth that may not be associated with inationary pressures,
but that may result, for example, from. . . nancial innovations (Issing
1999a, p. 20).
Although the rst pillar is sometimes presented as only referring to
M3 growth (e.g., see Begg et al. 2000), the ECB concerns itself not only
with the extent to which M3 growth deviates from the reference value,
it also analyzes the underlying causes. Quite a lot of attention is cur-
rently being paid, for instance, to the growth rates of the components
of M3, notably the growth rate of credit supplied to the private sector
(see section 3.4 for further details).
The second pillar is a broadly based assessment of developments
regarding the outlook on prices and the treats to price stability in the
euro area as a whole. A wide range of economic and nancial indica-
tors is used for this purpose. These variables can be grouped as (1) gap
measures (i.e., measures of the discrepancy between output, or its
factors of production, and their equilibrium values), (2) measures of
cost pressure, (3) international prices and exchange rates, and (4) other
asset prices. The indicators used are as follows:
HICP and other price indicators in the euro area. This includes producer
prices, which are a leading indicator for HICP ination. In addition
prices in the world markets for raw materials are closely monitored,
especially the price of crude oil.
4
Included in this category are the dea-
tor of the euro areas gross domestic product (GDP) as well as the
deators of its components. Also real estate prices are watched, where
possible.
Indicators for the real sector. This includes the real GDP and its
components, and also the production of the manufacturing, and other
sectors. The capacity utilization rate also belongs to this category of
indicators.
Condence indicators. Among these are the economic sentiment

indicator and various consumers and business sectors condence
indicators.
Indicators for the labor market. Employment and unemployment in the

whole economy and by sector, as well as wages and unit labor costs
(total and its components) and productivity belong to this category.
Exchange rates. The eurodollar exchange rate, and the (real and
nominal) effective exchange rates, are closely monitored by the ECB.
The initial decline of the euro vis--vis the dollar has had quite some
impact on ination in the euro area (see section 3.6.1 for a discussion).
Financial market indicators. To this group of indicators belong various

interest rates, as well as the term structure and stock market indexes.
The long-term yield and the term structure are often considered to
contain information concerning (expectations of) future ination and
economic growth.
Projections for ination and economic activity. The Governing Council

takes forecasts by otherslike the Consensus forecastsas well as the
14 Chapter 2
projections of the staff of the ECB into account in its decision-making
process (see section 3.5 for a discussion).
In the early years the Governing Council of the ECB discussed mone-
tary policy at every meeting, which takes place every fortnight.
However, in November 2001 it was decided that the Council should,
as a rule, assess the monetary policy stance only at its rst meeting of
the month. At these rst meetings interest rate decisions are normally
taken as well.
The ECB has a range of instruments at its disposal for implementing
monetary policy. To manage liquidity in the money market and steer
short-term interest rates, it uses open market operations. In addition
two standing facilities allow eligible counterparties to invest their daily
liquidity surpluses or to cover their overnight liquidity needs (see
gure 2.2).
Figure 2.2
Monetary policy operations of the Eurosystem. (Source: ECB 2004)
Types of transactions
Monetary policy operations Provision of liquidity Absorption of liquidity Maturity Frequency
Open market operations
Main refinancing
operations
Reverse transactions One week Weekly
Longer term refinancing
operations
Reverse transactions Three months Monthly
Fine-tuning operations Reverse transactions Foreign exchange swaps Nonstandardized Nonregular
Foreign exchange
swaps
Collections of fixed-term
deposits
Reverse transactions
Outright purchases Outright sales Nonregular
Structural operations Reverse transactions Issuance of debt
certificates
Standardized/
nonstandardized
Regular and
nonregular
Outright purchases Outright sales Nonregular
Standing facilities
Marginal lending facility Reverse transactions Overnight Access at discretion of
counterparties
Deposit facility Deposits Overnight Access at discretion of
counterparties
The two standing facilities are the marginal lending facility and the
deposit facility. Both facilities have an overnight maturity and are avail-
able to banks on their own initiative. The deposit facility is used for
mopping up liquidity from the banks at rates that are below market
rates. The rate set at this facility acts as a oor (lower limit) for short-
term money market rates. The marginal lending (or Lombard) facility
provides liquidity to the banks at rates usually above market rates. The
rate set at this facility thus acts as a ceiling (upper limit) for short-term
money market rates. The standing facilities thus constitute a corridor
for the (interbank) money market rate and signal the ECBs views on
interest rates in the medium run. Within that corridor the money
market rate is ne-tuned by means of open market operations.
In assessing the situation at the money market, EONIA plays an
important role. EONIA is short for Euro Over-Night Index Average. It
is a two decimal place rate that has been calculated and published by
the ECB at the end of every TARGET business day since January 4,
1999. The EONIA interest rate is the weighted average rate on trans-
actions reported to the ECB every business day by a representative
panel of banks, known as the EONIAPanel. EONIAis therefore repre-
sentative of the vast majority of euro-denominated overnight lending.
The importance of EONIAto the ECB is that it contains information on
the supply and demand equilibrium in the overnight market. The total
cash market volume reported for EONIA purposes is published daily.
Although it varies considerably, depending on market conditions, the
cash market averages around 40 billion.
There are four categories of open market operations. First, the main
renancing operations (MROs) are the most important open market
operations and represent the key monetary policy instrument of the
ECB (ECB 2004). They are executed as standard weekly tenders for
liquidity-providing transactions initially with a two-week maturity.
5
In
January 2003 the Governing Council of the ECB decided to shorten the
maturity of the MROs from two weeks to one week, effective as of
March 2004. Normally these operations consist of reverse transactions,
meaning the central bank buys assets under a repurchase agreement or
grants a loan against assets given as collateral. So these operations
provide funds for a limited and pre-specied period only.
Second, the longer term renancing operations, which are executed
as standard monthly tenders for liquidity-providing reverse transac-
tions with a three-month maturity, have the purpose of fullling the
additional longer term renancing needs of the nancial system. Third,
16 Chapter 2
ne-tuning operations will be executed as needed to smooth the effect
on interest rates of unexpected shocks in money market liquidity.
Finally, the Eurosystem may issue debt certicates and carry out
reverse or outright transactions whenever it wishes to adjust the struc-
tural position of the Eurosystem vis--vis the nancial sector.
The ECB also introduced a minimum reserve system, by which credit
institutions are required to hold compulsory deposits with national
central banks. The size of the required reserves is determined by
the size and composition of the liabilities on the balance sheet of the
institution concerned. For most liabilities included in the reserve base
the reserve ratio is 2 percent. The minimum reserve system serves two
main purposes: to contribute to the stabilization of money market inter-
est rates and to create sufcient structural demand for central bank
money. Interest rates are stabilized by allowing credit institutions to
use averaging provisions: reserve requirements are determined on the
basis of average daily reserve holdings over the maintenance period.
Since March 2004 the timing of the reserve maintenance period is such
that it will always start on the settlement day of the main renancing
operation following the Governing Council meeting at which the
monthly assessment of the monetary policy stance is pre-scheduled.
Furthermore, as a rule, the implementation of changes to the standing
facility rates are to be aligned with the start of the new reserve main-
tenance period.
2.4 Monetary Policy of the ECB
Table 2.1 shows the decisions of the ECB on interest rates. Just before
the ECB became responsible for monetary policy in the euro area, inter-
est rates were lowered in a coordinated decision by the various national
central banks in December 1998.
In the rst months of 1999 interest rates remained stable. Many
observers were worried at the time whether the new institution would
be able to withstand political pressures. The start of the ECB had not
been very promising after the political tinkering about the presidency
of the ECB (see Eijfnger and De Haan 2000). Furthermore, right
after the ECB took over the monetary policy responsibilities from the
Bundesbank, there was strong pressurenotably from the German
Finance Minister Oskar Lafontaineto cut interest rates. In April 1999
the ECB reduced interest rates by 50 basis points. At the press confer-
ence after the decision was taken, ECB President Duisenberg reported
on the reasons for the interest rate cut. He explained that the 12-month
growth rate of M3 growth stood at 5.2 percent in Februarynamely
above the reference value but at clearly a declined ratewhile the ina-
tion rate was somewhat below 1 percent. According to the ECBs
assessment it appeared unlikely that HICP increases would be out of
line with the Eurosystems denition of price stability, while at the
same time economic growth prospects worsened toward the end of the
year.
In November 1999 interest rates were raised 50 basis points. Accord-
ing to Duisenberg, the main argument for reversing what was then
Table 2.1
ECB interest rates, January 1999December 2003
Main renancing operations
Fixed rate Variable rate Marginal
Deposit tenders, tenders, minimum lending
With effect from: facility xed rate bid rate
b
facility
January 1, 1999
a
2.00 3.00 4.50
April 9, 1999 1.50 2.50 3.50
November 5, 1999 2.00 3.00 4.00
February 4, 2000 2.25 3.25 4.25
March 17, 2000 2.50 3.50 4.50
April 28, 2000 2.75 3.75 4.75
June 9, 2000 3.25 4.25 5.25
June 28, 2000 3.25 4.25 5.25
September 1, 2000 3.50 4.50 5.50
October 6, 2000 3.75 4.75 5.75
May 11, 2001 3.50 4.50 5.50
August 31, 2001 3.25 4.25 5.25
September 17, 2001 2.75 3.75 4.75
November 9, 2001 2.25 3.25 4.25
December 5, 2002 1.75 2.75 3.75
March 7, 2003 1.50 2.50 3.50
June 6, 2003 1.00 2.00 3.00
Source: www.ecb.int.
a. On December 22, 1998, the ECB announced that, as an exceptional measure between
January 4 and 21, 1999, a narrow corridor of 50 basis points would be applied between
the interest rates for the marginal lending facility and the deposit facility in order to facil-
itate the transition to the new regime by market participants.
b. On June 8, 2000, the ECB announced that, starting from the operation to be settled on
June 28, 2000, the main renancing operations would be conducted as variable rate
tenders.
18 Chapter 2
called the precautionary interest rate reduction was the fact that around
the beginning of the summer the balance of risks to future price
stability gradually moved toward the upside. Ination rates were
expected to increase mainly as the result of the increase in energy prices
earlier that year, which was working its way through to consumer
prices. An increase in interest rates should help to counteract further
liquidity growth over the medium termin the period July to Sep-
tember M3 growth stood at 5.9 percentand contribute to maintain-
ing ination expectations safely below 2 percent.
In 2000 interest rates were further increased in six subsequent steps.
Except for the increase of June 2000, interest rates rose by 25 basis
points. During this period there was sometimes confusion as to the role
of the eurodollar exchange rate. Some observers thought that the ECB
had changed its policies and was now trying to stabilize the exchange
rate. However, the ECB does not have an exchange rate target. Still the
exchange rate is one of the indicators used in the second pillar and is
therefore closely observed by the ECB. There was also a feeling that the
euro was undervalued. Occasionally the ECB intervened, sometimes
jointly with the central banks of the United States and Japan. Accord-
ing to the ECB press release of September 22, 2000, this concerted
intervention was motivated by the shared concern about the potential
implications of recent movements in the euro exchange rate for the
world economy. In November 2001 the ECB intervened again, but
now the central banks of the United States and Japan did not join in.
In section 3.6 we will deal in more detail with the exchange rate policy
of the ECB.
At its meeting on May 10, 2001, the Governing Council of the ECB
decided to reduce interest rates. This decision was regarded as an
adjustment to somewhat lower inationary pressures over the medium
term. Furthermore M3 growth had been on a downward trend, stand-
ing at 4.8 percent over January to March 2001. The ECB also stated that
the monetary growth gures were distorted upward by noneuro area
residents purchases of negotiable paper included in M3. This distor-
tion was estimated to be around half a percentage point of the annual
growth rate of M3. There was a further distortion due to noneuro area
residents holdings of other marketable paper included in M3. The size
of this distortion was uncertain when the Governing Council took its
decision. At the end of August a further rate cut of 25 basis points took
place. In September the Fed and the ECB reduced their rates by 50 basis
points to counteract the feared negative impact of the terrorist attacks
on the United States, followed by a further cut of 50 basis points in
November.
At the beginning of 2002 euro banknotes and coins were introduced.
The euro conversion was successfully carried out (see Sidebar 2). After
a long period of unchanged interest rates, the Governing Council
decided at its meeting of December 5, 2002, to lower the key ECB
interest rates by 50 basis points, because the arguments in favour of a
cut in the key ECB interest rates have strengthened. The evidence that
inationary pressures are easing has increased, owing in particular to
the sluggish economic expansion. Furthermore, downside risks to eco-
nomic growth have not vanished.
6
In 2003 rates were cut twice. In March and June the Governing
Council decided to reduce the interest rates by 25 and 50 basis points,
respectively. The Council considered that the outlook for price
stability over the medium term had improved, owing in particular to
the subdued pace of economic growth and the appreciation of the
exchange rate of the euro. Although the growth rate of M3 was far
above the reference valuein fact, it increased to 7.1 percent in the
period from November 2002 to January 2003, compared with 6.9
percent in the period from October to December 2002it was not
expected to be inationary. As Duisenberg put it in his press confer-
ence on March 7, 2003:
The continued strong monetary growth reects an ongoing pronounced pref-
erence for liquidity in an environment of high nancial, economic and geopo-
litical uncertainty. Although liquidity remains ample, it is not expected at this
stage to give rise to inationary pressures, given the current economic context
and the expectation that some of the portfolio shifts will be reversed once the
nancial market uncertainty diminishes. Recent data on loans to the private
sector, notably the weak growth in loans to nonnancial corporations in late
2002, conrm this assessment.
Similar arguments were used to explain the interest rate reduction
in June 2003. At the time, ination rates were expected to decline to
below 2 percent over the medium term, following recent movements
in the exchange rate of the euro and given the sluggish growth per-
formance of the euro area. According to the ECB, the strong expansion
of M3 should not for the time being adversely affect this outlook. No
specic reasons were given why, in contrast to the previous step, rates
were now cut by 50 basis points.
20 Chapter 2
1 Too Little, Too Late?
According to some observers, the ECB reduced interest rates too little
and too late in 2001. In November 2001, Sinn argued, for instance: The
European Central Banks failure to lower interest rates at its last meeting,
was very disappointing. Is the boom in Ireland and Finland so impor-
tant for Europe that it prevents battling recession in the heart of the
Continent? (Sinn 2001, p. 2).
Sinn suggests that the decentralized decision-making structure of the
ECB has led to suboptimal decisions. The table below shows the capac-
ity utilization rates in the euro area countries around the time of the ECB
decisions to which Sinn refers, namely the last two quarters of 2000 and
the rst two quarters of 2001. Nevertheless, in terms of the capacity uti-
lization rate of manufacturing, Germany was still doing better at the time
than the euro area as a whole, even better than Ireland.
Table 2.2
Capacity utilization rates (%) in the euro area, 20002001
Capacity utilization
Country 2000:III 2000:IV 2001:I 2001:II
Euro area 83.9 84.7 84.4 83.6
Austria 85 85 84.2 84
Belgium 84.2 84.5 84.8 82.7
Finland 87 86.7 87.3 86
France 87.9 89.1 88.8 86.9
Germany 86.0 86.3 86.9 85.7
Greece 77.8 78.4 78.2 79.3
Ireland 78.5 81.5 79.8 80.4
Italy 78.9 79.8 79.5 79.4
Netherlands 85 84.6 85.2 84.8
Portugal 82 80.9 82.5 82
Spain 80.3 80.8 80.1 79.7
Source: Datastream.
2 The Changeover to the Euro
The changeover to euro coins and banknotes on January 1, 2002, marked
a big leap in the process of monetary integration in Europe. A remark-
able feature of the changeover to euro currency was the different periods
of dual circulation of national and euro currency in many countries.
While Germany had formally no dual circulation period, Austria,
Belgium, Finland, Greece, Italy, Luxembourg, Portugal, and Spain opted
for the maximum of two months as allowed by the Maastricht Treaty.
Between the extremes were the Netherlands (4 weeks), Ireland (6 weeks),
and France (7 weeks). Although the experiences with the changeover dif-
fered widely, the changeover was successful. The conversion of auto-
matic teller machines (ATMs) had been completed on the rst working
day (January 2) in Austria, Germany, Luxembourg, and the Netherlands.
By January 4 nearly all countries, except Italy and Spain, had effected the
ATM conversion. Saturday, January 5, was an important test for the
success of the changeover as the volume of business was higher than on
all other days of the rst week counted together. At the end of this day,
the European Commission concluded that . . . it would appear that,
overall, queues in shops, and in large stores too, were still no longer than
usual (European Commission, Press Release, January 7, 2002). Accord-
ing to the Commission, on average, just under two-thirds of cash pay-
ments were made in euros. On January 11 the Commission concluded
that the euro changeover was practically complete. On average, almost
85 percent of the number of cash payments were then made in euros, and
over two-thirds of the vending machines had been converted to the euro
(European Commission, Press Release, January 11, 2002).
Source: Eijfnger (2002)
2.5 ECBs Evaluation of Its Monetary Policy Strategy
On May 8, 2003, the Governing Council of the ECB made the results
of the evaluation of its monetary policy strategy public. The opinion
of the Council was that so far the strategy had worked satisfactorily.
According to Issing (2003, pp. 45):
Since 1999, medium and long-term ination expectationsas measured by
survey data or nancial market indicatorshave remained consistent with the
ECBs denition of price stability. This is all the more remarkable given that
the ECB started without a track record of its own and that it has experienced
a number of sizeable adverse price shocks. As a result of these shocks, HICP
ination was above (and sometimes signicantly above) 2% for quite some
time. But, as the shocks gradually unwound, so ination has returned towards
levels compatible with price stability. Medium- and long-term ination expec-
tations remained well anchored throughout this period.
As table 2.3 shows, the year-ahead consensus forecast for ination on
the dates when the ECB cut interest rates varied in a narrow range
from 1.6 to 1.8 percent. Although actual ination exceeded 2 percent
almost continuously since mid-2000, this did not lead to an increase in
expected ination. The ECBs Survey of Professional Forecasts had
shown the expectation over the ve-year horizon to be 1.8 to 1.9 percent
since the inception of the monetary union (Kieler 2003).
The Governing Council made two clarications in view of the eval-
uation. First, the Council rened its denition of price stability. The
Council agreed to maintain ination rates below but close to 2 percent
over the medium term. According to the ECB press release, This clar-
ication underlines the ECBs commitment to provide a sufcient safety
margin to guard against the risks of deation. It also addresses the issue
of the possible presence of a measurement bias in the HICP and the
implications of ination differentials within the euro area.
As was pointed out by Issing (2003), the main reason for keeping
ination below but close to 2 percent was the need for a safety margin
against potential risks of deation. In instances of strong deationary
pressures, monetary policy could become ineffective if the central bank
interest rate management is constrained by a liquidity trap or a zero-
bound problem. The analyses of the ECB showed that such constraints
would not pose a signicant threat if ination remains sufciently
above zero. The aim to maintain ination rates close to 2 percent further
took into account a potential measurement bias in the HICP and the
22 Chapter 2
Table 2.3
Rate cuts and consensus ination forecasts
Date Rate cut (%) Year-ahead consensus forecast
April 1999 0.50 1.6
May 2001 0.25 1.8
August 2001 0.25 1.8
September 2001 0.50 1.8
November 2001 0.50 1.7
December 2002 0.50 1.8
March 2003 0.25 1.7
Source: Kieler (2003).
ination differentials of a structural nature within the euro area. In
chapter 3 we discuss these issues in some detail.
Second, the Council rened the structure of its policy making,
though not departing from the objective to base policy decisions on a
comprehensive analysis of the risks to price stability. The Council noted
that their perception of both pillars of the monetary policy strategy
over time had changed and been enlarged. At the core was the aim to
provide clearer communication and means of verifying information in
coming to a unied decision on the risks to price stability. Anew struc-
ture was given to the introductory statement of the president. It will
start with the economic analysis to identify short- to medium-term
risks to price stability, followed by the monetary analysis to assess
medium- to long-term trends in ination in view of the close relation-
ship between money and prices over extended horizons. As in the
past, monetary analysis was to take into account developments in a
wide range of monetary indicators, including M3, its components and
counterparts, notably credit, and various measures of excess liquidity.
According to the Governing Council, the monetary analysis was
mainly seen as a means of cross-checking, from a medium- to long-
term perspective, the short- to medium-term indicators of economic
performance. To stay focused on the longer term nature of the refer-
ence value for M3 growth, the Governing Council decided to discon-
tinue the practice of an annual review of this reference value. The ECB
(2003a, p. 24) explains this decision as follows:
. . . the practice followed thus far by the Governing Council of annually review-
ing the reference value may have contributed to the occasional misperception
that the reference value is announced for a specic year, similar to the past
practice of some monetary targeting central banks. Since the reference value is
based on medium-term assumptions for real GDP growth and the income
velocity of moneyand since experience has shown that these assumptions
change only graduallythere may in fact be no need for an annual review of
the technical assumptions underlying the computation of the reference value.
Although the statements of the ECB were intended merely to be a
clarication of its concern with price stability, many observers inter-
preted them to be a change in the ECBs ination objective. For
instance, Sibert (2003) called it a distinctly dovish change in policy.
When it was originally announced that ination was to be kept at lower
than 2 percent, the natural interpretation was not that the ECB was
aiming to keep ination just below 2 percent. Since the oor was zero,
24 Chapter 2
the obvious conclusion was that the ECB was aiming for around 1
percent, with the costs of deviating from this rising sharply as ination
either rose to two percent or fell to zero percent.
Likewise the discussion of the two-pillar strategy was widely inter-
preted as diminishing the importance of the rst pillar in the monetary
strategy despite ECB ofcials stress on its continuity. For instance,
Svensson (2003) summarized the Governing Council decision as
follows: Keeping the two-pillar strategy but reducing the prominence
of the rst pillar by putting it second and discussing the monetary
pillar (relabeled monetary analysis) after the broadly-based assess-
ment (relabeled economic analysis), seeing it mainly as a means of
cross-checking the economic analysis. This is a change in the right
direction, but it is not enough.
7
As is evident from the preceding quotes, the ECB is being closely
watched by many academic and professional economists. Also the
European Parliament reviews its monetary policy regularly (see
sidebar 3 for further details). In chapter 3, we offer our synthesis of the
debate on the monetary policy strategy of the ECB.
3 ECB Watchers: Bachelors Wives and Maidens Children
Are Well Trained
Like many other central banks, the ECB is closely monitored by acade-
mic and professional watchers, who regularly publish their assessment
of the ECB and their comments on its monetary policy. A prominent
group of academic ECB watchers are the members of the Panel of
Economic and Monetary Experts who have been submiting their brief-
ing papers quarterly since June 2000 to the Committee on Economic and
Monetary Affairs of the European Parliament.
8
In accordance with Article
113(3) of the Treaty on European Union, this committee is responsible for
maintaining a monetary dialogue with the president of the ECB. These
academics have inuenced the ECBs policies to some extent. For
example, the publication of ination projections by the ECB for the rst
time in December 2001 was in response to a call in the monetary dia-
logue with the ECB president during 2000.
It is remarkable that professional ECB watchersabove all, nancial
market expertschange their points of view very quickly. Against the
background of a gloomy economic outlook, a stronger euro, easing ina-
tionary pressure and turbulence in nancial markets during the summer
of 2002 came, in the course of the year, increasingly louder calls for more
2.6 Conclusions
Before the ECB started operations, the main elements of its monetary
policy were decided on by the Governing Council in October 1998. The
original strategy consisted of three elements. First was the Councils
formal denition of price stability, namely to abide by a yearly ina-
tion for the euro area of not more than 2 percent in the medium term.
Second was the prominent role given to money growth in the assess-
ment of the risks to price stability. This became known as the rst pillar
of the ECBs monetary policy. Third was to use a wide variety of eco-
nomic and nancial variables in providing a broadly based evaluation
of any threats to price stability. This was the second pillar.
interest rate reductions. The same analysts had argued for an interest rate
hike only a few weeks before but were now demandingwith the same
amount of pressurean easing of monetary policy.
The economists of JP Morgan Chase, for example, expected the ECB to
lower interest rates to 2 percent in the aftermath of the terrorist attacks
of September 11, 2001. By the end of January 2002 they claimed to see
the turning point in the interest rate cycle at 2.75 percent. With the rst
signs of economic recovery in the rst quarter, the experts changed their
minds and predicted an interest rate increase.
It is doubtless vital for the accountability, transparency, and commu-
nication strategy of the ECB to engage an active debate over monetary
policy issues and to exchange views with independent academic and
nonacademic ECB watchers. Sometimes the critique, both from academic
and professional ECB watchers, is not particularly practicable, and some-
times the critics characterize the ECBs polices inappropriately. For
instance, Begg et al. (2000) refer to the rst pillar as a money growth
reference target.
Nevertheless, the communication strategy of the ECB can be criticized
(see chapter 4 for a discussion). The ECB communications on the evalu-
ation of the two pillars in its monetary policy strategy were misleading.
At the press conference when the results were made public, the ECB of-
cials claimed that the evaluation was merely a clarication. However, the
statements on the price stability objective and the presentation of the
outcome of the policy discussion were such that they were widely inter-
preted as indicating that the ECB had changed its monetary policy strat-
egy. So there is some question whether words and deeds were in
agreement, especially since some central bankers privately communi-
cated that the rst pillar had been pushed aside.
26 Chapter 2
In May 2003 the ECB announced the outcomes of its internal evalu-
ation of its strategy. Although the ECB stressed continuity and stated
that the decisions taken were all about clarication, these decisions
were perceived widely as a change in its monetary policy strategy. The
ECB in fact did still seek to maintain the ination rate below or close
to 2 percent over the medium term. The use of the two-pillar frame-
work of the strategy was conrmed to be a tool to organize the infor-
mation relevant for assessing the different risks to price stability. It was
also announced that the introductory statement of the president at the
ECB Press Conference following a Governing Council rate-setting
meeting was to start with an analysis identifying the short- to medium-
term risks to price stability. This part of the assessment was to be called
the economic analysis. After the assessment of the medium- to long-
term risks to price stability, the monetary indicators were to be
examined. This second part of the assessment was to be called the
monetary analysis. The Governing Council emphasised that the
monetary analysis would serve mainly as a means of cross-checking,
from a medium- to long-term perspective, the short- to medium-term
indications of the economic analysis. This decision has been widely
seen as downgrading the importance of the (previous) rst pillar.
3.1 Introduction
In the academic literature the monetary policy strategy of the ECB has
been severely criticized. For instance, Begg et al. (2000, p. 6) argue:
At a time when more and more central banks replace money-growth targeting
with (expected) ination targeting, and make efforts at being transparent, the
ECBs strategy is unavoidably seen as obscure, often even archaic.
This chapter provides an assessment of the ECBs monetary policy
strategy to examine whether this critique is justied. We start with an
analysis of the predictability of interest rate decisions by the ECB. After
a review of the literature, we present some new results based on analy-
ses of forward rates and newspaper reports (section 3.2). The next two
sections deal with the elements of the ECBs strategy that have been
most severely criticized, namely the denition of price stability (section
3.3) and the role of the monetary analysis (section 3.4). Subsequent
sections discuss ination forecasts (section 3.5), the role of the external
value of the euro in the monetary policy strategy of the ECB (section
3.6), the questions of whether asset prices should play a role in the ECB
policies (section 3.7), and whether interest steps should be small or
large (section 3.8). The nal section offers our conclusions.
3.2 Predictability of Policy Decisions
As follows from the citation of Begg et al. (2000), some observers argue
that the ECB sometimes behaved in a rather erratic and nontranspar-
ent way.
1
Issing (2001a, p. 15) argues that one possible way to approach
the transparency of monetary policy decisions is to analyze the pre-
dictability of the decisions taken by the Governing Council. If the
3
The ECBs Strategy: An
Assessment
28 Chapter 3
stability-oriented strategy were indeed to complex and ultimately not
transparent, as claimed by some of our critics, then we should expect
monetary policy decisions to be very imperfectly forecasted.
2
In order
to examine this issue more systematically, we analyze the development
of forward market rates on a daily basis, as well as newspaper reports.
3.2.1 Analysis of Forward Rates
Financial market prices may contain information about ination and
interest rate expectations. Therefore they are often used for measuring
market expectations. Sderlind and Svensson (1997) provide a survey
of methods to extract information about market expectations from asset
prices for monetary policy purposes. Traditionally interest rates and
forward exchange rates have been used to extract expected interest
rates, exchange rates, and ination. More advanced approaches rely on
implied forward interest rates (market consensus of future interest
rates based on the relationship between spot rates) to extract expected
future time-paths. Very recently, methods have been rened to extract
not only the means but also the whole (risk-neutral) probability distri-
bution from a set of option prices. Svensson (1993), Sderlind (1995),
and Sderlind and Svensson (1997) use forward interest rates (nominal
interest rates agreed upon today for an investment period starting in
the future) as an indicator of the monetary stance of a central bank.
They suggest the use of forward rates, because these reliably indicate
market expectations of future short-term interest rates, ination, and
risk premiums in general. Forward rates presumably consist of four
unobservable components: expected real interest rates, expected future
ination, and the relevant risk premiums (i.e., the forward-term risk
premium and the ination risk premium). Isolating any of these com-
ponents, however, is a difcult exercise as the four components are
interrelated.
In recent years many papers focusing on the predictability of mone-
tary policy in the United States have been published. The question of
whether market participants were able to anticipate the Feds interest
rate decisions has, for instance, been analyzed using Fed funds futures
prices (e.g., see Krueger and Kuttner 1996; Kuttner 2001; Poole and
Rasche 2000; Owens and Webb 2001).
Following the approach by Poole and Rasche (2000), Gaspar et al.
(2001) have analyzed whether the announcements of ECB decisions
have a signicant impact on the behavior of overnight rates (EONIA)
in Europe. The bottom line of this research is that if the market antici-
pates the systematic behavior of the central bank, it should only adjust
to news (i.e., information innovations) but not to the central banks
actual announcements of monetary policy decisions. The authors con-
clude that the ECB monetary policy announcements do not signi-
cantly affect the mean interest rates. These ndings are consistent with
the assumption that markets do not make systematic mistakes in antic-
ipating the ECBs monetary stance. The results of Gaspar et al. suggest
that markets were able to predict the ECBs interest rate decisions quite
accurately over the period of analysis (January 1, 1999, to March 23,
2001). Table 3.1 is reproduced from this study. It shows the success of
the market in predicting the ECBs interest rate movements on the day
before the meeting of the Governing Council, distinguishing between
the times when the ECB moved interest rates and when it left rates
unchanged. Of the ECB interest rate changes taken into account, only
one, namely the April 1999 decision, caught the markets by surprise.
Likewise in only one case the markets expected a move, while the ECB
rates remained stable. Somewhat less supportive evidence for the
predictability of ECB moves is reported by Ross (2002), who nds that
while ECB rate hikes were generally well predicted, the markets have
had more difculty in fully and correctly anticipating ECB rate cuts in
terms of either timing or magnitude.
In the remainder of this section, we examine whether in the forward
rates nancial markets anticipated the interest rate steps of ECB. We
calculate the differences between the actual money market rate and the
three-month EURIBOR future. This difference yields information about
the market participants interest rate expectations. We compare these
expectations with the ECBs actual interest rate moves. Figure 3.1
shows that the markets anticipated most of the ECBs interest rate
moves. Sometimes the move was expected to take place earlier, and
sometimes the size of the step was over- or underestimated.
The ECBs Strategy: An Assessment 29
Table 3.1
Have money markets anticipated ECBs decisions?
Market expectations
Move No move Number of observations
ECB Move 88% 12% 8
No move 8% 92% 36
Source: Gaspar et al. (2001).
30 Chapter 3
Let us turn to examine some of the ECB decisions (see table 2.1 for
an overview of the decisions). Aparticularly controversial decision was
the ECBs rst interest rate decrease in April 1999. The crises in Russia
and Brazil severely affected condence in the world economy and low
oil prices created fears of deation. The ECB was already under much
pressure, but it was only April 8, 1999, when the central bank lowered
its key rate by 50 basis points. For the market participants the decision
came too late; they had in fact expected the rates to remain and their
fears of deation had dissipated.
The decision of November 1999 was expected earlier. About one
month before the ECBs decision to raise the rate by 50 basis points, the
markets had priced-in a tightening of monetary policy, in anticipation
of a big step of 75 basis points. For some critics the increase was simply
a correction of the earlier unnecessary decrease of April 1999; for
others, it was the ECBs reaction to the rising ination. In either case,
however, the move was not unexpected since it was announced by the
ECB well in advance.
The ECB decision of February 2000 caught nancial markets by sur-
prise. Some nancial market participants were about to believe that the
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
12-3-98 4-3-99 8-3-99 12-3-99 4-3-00 8-3-00 12-3-00 4-3-01 8-3-01 12-3-01
ECB interest rate move Interest expectations extracted from 3M futures
Figure 3.1
Interest rate expectations extracted from three-month futures
ECB was acting sluggishly and only able to make big moves, and they
were puzzled when the ECB raised rates by only 25 basis points. This
was the beginning of a series of trip steps. The ECB decisions of
March, April, June, and August were generally expected. Likewise the
step of October 2000 had been expected by the markets, but compared
to the earlier moves it had been anticipated very late. During the period
from the end of August 2000 and the last days of September, the
markets did not expect an interest rate move. Only a few days prior to
the ECB meeting, forward rates disclosed an increase in interest rate
expectations.
The May 2001 decision was also a surprise to many nancial market
participants (see gure 3.2). Whereas the majority of the market
participants had bet on a small step downward by the beginning of
January and even on a 50 basis points step by mid-April, the ECB actu-
ally did not lower its key rate until May 10. Meanwhile the markets
had accommodated to the belief that an interest rate decrease would
not t into the ECBs monetary strategy at that time, with M3 remain-
ing persistently above its reference value and HICP ination above 2
percent. As explained in chapter 2, the ECB justied the move by the
latest monetary developments and the temporary upward distortion of
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
1-1-01 1-15-01 1-29-01 2-12-01 2-26-01 3-12-01 3-26-01 4-9-01 4-23-01 5-7-01 5-21-01
Actual ECB move Interest rate expectations extracted from 3M futures
Figure 3.2
Interest rate expectations in May 2001
32 Chapter 3
the monetary aggregate due to noneuro area residents purchases of
negotiable paper included in M3.
The decision of August 2001 did not come as a surprise. The next
decision to reduce rates after the terrorist attack of September 11, was
decided upon by means of teleconferencing. This was the rst decision
taken between two regular Council meetings, and it was widely
accepted, though it had not been expected. At the regular meeting on
September 13, the Council decided to leave rates unchanged. This deci-
sion was justied by the imminent political and economic uncertainty
after the terrorist attacks and the announcement that the ECB would
coordinate its activities with the Federal Reserve and other major
central banks. These arguments were in line with markets perceptions.
But what was not easy to understand was that the ECB nally lowered
rates by 50 basis points with some lag behind the Fed. This gave way
to speculations that the ECB had taken an ad hoc decision. The specu-
lation was nourished by the subsequent change in the minimum bid
rate for the next renancing operation, which was settled on Septem-
ber 19, 2001.
The step of November 2001 did not come as a surprise, although the
markets had only anticipated a small step. All in all, we can conclude
that the evidence is mixed. By and large the markets predicted the ECB
moves quite accurately. Only in a few cases did the ECB take the market
by surprise, while in other cases the timing of the ECB steps was not
entirely in line with market expectations.
3.2.2 Expectations according to Newspaper Reports
In a further attempt to analyze to what extent nancial markets were
caught by surprise, we systematically gathered the newspaper reports
about ECB policy decisions in the Financial Times (FT) and the Frank-
furter Allgemeine Zeitung (FAZ) in 1999 and 2000. Generally, journalists
are in close contact with nancial market analysts and are therefore able
to examine whether a certain policy decision was in line with nancial
market expectations. Table 3.2 reports the outcomes from this analysis.
After each meeting of the ECBs Governing Council either a press con-
ference took place and/or a press release was issued. The main deci-
sion is shown in the second column of table 3.2, while the third and
fourth columns show whether according to the FT and the FAZ this
decision was in line with nancial market expectations. We only report
those decisions on which the journalists had something to say about
nancial markets expectations.
Table 3.2
Monetary policy decisions and nancial market expectations, 19992000
Council meeting Decision FT report FAZ report
December 22, Rate cut Many analysts have
1998 been expecting an ECB
rate cut in the rst half
of next year (FT,
122398)
January 7, 1999 No change Majority of observers
expect constant rates for
next three to four
months (FAZ, 1899)
January 21, 1999 No change ECB will lower rates by
0.5 percentage points
according to Salomon
Smith Barney (FAZ,
12299)
February 18, No change In line with
1999 expectations (FT,
21999)
April 8, 1999 Decrease 50 Cut bigger than Traders say that size of
basis points expected (FT, 4999) the cut surprised them
(FAZ, 4101999)
May 6, 1999 No change Most economists expect No one had taken into
euro-zone rates to account that ECB would
remain unchanged until change interest rates
at least September (FT, again (FAZ, 5799)
5799)
July 1, 1999 No change In line with
expectations
(FT, 7299)
July 15, 1999 No change Most economists expect Markets had expected
the 2.5% rate to stay no change (FAZ,
until next year (FT, 71699)
71699)
July 29, 1999 No change In line with
expectations (FT,
72099)
August 26, 1999 No change Decision was expected
(FAZ, 82799)
September 9, No change Markets expect Decision was expected
1999 tightening before end of (FAZ, 91099)
year (FT, 91099)
September 23, No change Most economists expect
1999 no rate rise before rst
quarter of 2000 (FT,
92499)
34 Chapter 3
Table 3.2
(continued)
November 4, Increase 50 Markets had anticipated ECB did not disappoint
1999 basis points the move, economists nancial market
welcome the size of the participants, decision
increase, some nancial was for majority of
market participants had analysts ausgemachte
expected rise of 0.25 Sache, next increase not
(FT, 115-99) expected before mid
2nd quarter of 2000
(FAZ, 11599)
December 15, No change Bundesverband
1999 deutscher Banken
praises ECB for
information policy of
monetary policy stance
(FAZ, 121699)
January 20, 2000 No change Economists divided Rate rise of 25 basis
over size of next move, points expected in
some predicting a 50 Spring (FAZ, 12100)
basis point rise in
March (FT, 12100)
February 3, 2000 Increase 25 Economist are divided
basis points how sharply ECB may
rise rates (FT, 12100);
many analysts had been
expecting either no
change or a 50 basis
point move (FT, 2400)
February 17, No change
2000
March 2, 2000 No change Decision won broad
approval, rise would
have created confusion
(FT, 3300); most
market participants had
expected rates to
remain unchanged (FT,
3200)
March 16, 2000 Increase 25 Rise came as little Many market observers
basis points surprise to markets had expected this
which had expected an decision after hints of
increase (FT, 31700) Duisenberg; decision
was widely expected
(FAZ, 31700)
Table 3.2
(continued)
April 13, 2000 No change As expected; many
economists expect ECB
to raise rate to 4%
before summer recess
(FT, 41400)
April 27, 2000 Increase 25 Increase was in line Exchanges were not
basis points with expectations in surprised (FAZ,
nancial markets (FT, 42800)
42700)
May 11, 2000 No change Decision had been
widely expected (FT,
12500)
May 25, 2000 No change Decision strengthened
expectations that next
rise will come in June
(Ft, 52600); most
economists expected the
ECB to leave rates on
hold (FT, 52600)
June 8, 2000 Increase 50 ECB surprised nancial Traders surprised, rise
basis points markets; most analysts of only 25 points had
had expected rise by been expected (FAZ,
0.25 percentage points 6900)
(FT, 6900)
June 21, 2000 No change Few people were
surprised when ECB
elected to keep rate
unchanged (FT,
62600)
July 20, 2000 No change Decision conrmed Decision was expected
expectations that next (FAZ, 72100)
move is not likely
before September (FT,
72100)
August 31, 2000 Increase 25 Money market and Decision was widely
basis points some economists had expected (FAZ, 9100)
been looking for a
bolder move (FT,
9100)
October 5, 2000 Increase 25 Biggest surprise in the ECB increases rates
basis points bond market was ECBs surprisingly (FAZ,
decision to raise rates; 10600)
move caught many in
the nancial markets by
surprise (FT, 10600)
36 Chapter 3
According to this analysis the policy of the ECB during 1999 was in
line with nancial market participants expectations. As the Financial
Times (December 3, 1999) reported:
. . . the ECB is starting to earn a reputation as a central bank that does not want
to ne-tune the euro-zone economy by making frequent, often unexpected,
interest rate changes. If predictability is the key to a central banks credibility,
as Mr. Duisenberg recently asserted, the ECB is moving in the right direction.
In 2000 the situation changed. In contrast to our analysis of forward
rates, the decision of October 2000 caught many nancial markets by
surprise according to the newspaper reports summarized in table 3.2.
Still, this analysis supports the conclusion that, by and large, the ECB
policy moves were in line with nancial markets expectations.
3.3 Ination Objective
The initial ECB denition of price stability has been severely criticized
in the literature as being asymmetric and ambiguous. It has been
suggested that the ECB should make its objective more precise, for
instance, by announcing a lower bound in the denition or by speci-
fying the objective in terms of a point ination rate. The discussion on
Table 3.2
(continued)
October 19, 2000 No change Move welcomed by
economists (FT,
102000) A repetition
of the 0.25 percentage
point rise had been
deemed highly unlikely
(FT, 101900)
November 2, No change Financial markets had
2000 expected decision (FT,
11300)
November 16, No change Decision was in line
2000 with market
expectations (FT,
111700)
November 30, No change Step widely anticipated
2000 in nancial markets (FT,
12100)
the denition of price stability is summarized in section 3.3.1. Section
3.3.2 deals with the debate on the question of whether an ination
objective of below but close to 2 percent is too low.
3.3.1 Denition
The price index used to calculate ination should be credible. A price
measure constructed by the central bank itself may therefore lack cred-
ibility, as the central bank may be tempted to manipulate that measure
to achieve its target. As we pointed out before, the ECB denes ina-
tion on the basis of the HICP, which is calculated by Eurostat. The HICP
is a Laspeyres-type index of consumer spending, similar to the US con-
sumer price index (CPI) and the UK retail prices index, excluding mort-
gage interest payments (RPIX). The HICP index is published monthly
and in a timely manner. Furthermore it is very rarely revised, and it
can be aggregated across countries (Camba-Mendez 2003).
Some critics of the ECB have argued that a more transparent deni-
tion would formulate price stability in terms of core ination (e.g.,
see Gros et al. 2000). Although the ECB also publishes HICP ination
excluding certain items like unprocessed food stuff and energy cost (see
gure 3.3), the ECB rejects a denition of price stability based on core
ination as it, no doubt, would invite considerable criticism because of
the arbitrary nature of deriving such a measure (ECB 2003a). We there-
fore concur that HICP ination is an appropriate measure to be used
for the denition of price stability.
3
In providing a denition of price stability, the ECB has specied its
medium-term ination objective in more precise terms than some other
central banks, such as the US Federal Reserve or the Bank of Japan,
which do not offer quantitative denitions of their targets. However,
in comparison to the objectives of central banks with an ination-
targeting strategy, the ECB denition of price stability is less precise.
Some ination targeting central banks have adopted point targets
(Canada, Sweden, and the United Kingdom) while others have
adopted target ranges (Australia and New Zealand).
4
For those banks
that have adopted ranges, the lower bound is explicit, and the mid-
point of the range is generally understood to represent the preferred
ination outcome. The policy horizon for most ination-targeting
central banks is one and a half to two years (Kieler 2003). As is pointed
out by Castelnuovo et al. (2003), the announcement of a range permits
the central bank to clearly signal the uncertainty surrounding future
price developments and the imperfect controllability of ination,
38 Chapter 3
particularly at short horizons. Moreover a range can accommodate
moderate and gradual variations in the optimal ination rate over time.
A possible drawback of a range objective is that its bounds could be
seen as hard edges, as thresholds values. For that reason it is prefer-
able to use a point objective. A point objective can also signal to eco-
nomic agents a precise ination target.
The ECBs denition of price stability provides a less clear-cut
demarcation of the banks ination preferences than an ination target
would. First, it does not follow from the denition of price stability that
the ECB is indifferent between all ination rates in the 0 to 2 percent
range, or that it aims for the midpoint of that range. Second, the
medium-term horizon over which price stability is to be maintained
is not specied. The ambiguity about the ECBs objective may hamper
communication and understanding of its policies (Kieler 2003).
The clarication that price stability means an ination rate below
but close to 2 percent is considered to be an improvement by most
observers, although many argue that some ambiguity remains. The
argument by the ECB that this clarication is not a policy change is
also contested. At the press conference on the outcomes of the evalua-
tion of the monetary policy strategy of the ECB, Issing declared that
the close to 2 percent objective is not a change: it is a clarication of
what we have done so far, what we have achievednamely ination
expectations remaining in a narrow range of between roughly 1.7
percent and 1.9 percentand what we intend to do in our forward-
looking monetary policy. However, as pointed out by Svensson (2003),
in earlier statements the ECB called an ination rate of about 1 percent
in line with the objective.
No matter whether it is a continuation or a change of policy, some
ambiguities remain even after the clarication. For one thing, it is
still not fully clear what close to 2 percent means. Furthermore it
remains unclear to what time frame the medium term refers. For
instance, if a shock pushes ination above the 2 percent level, how long
will it take the ECB to restore price stability? This question is quite
relevant as ination in the euro area was often above the 2 percent
level in 2001 to 2002 (see gure 3.3). The ECB refused to give a clear
position on this issue because of the uncertainty about the monetary
transmission mechanism.
As gure 3.3 shows, the ECB was successful in keeping ination at a
low level in the euro area. Nevertheless, ination was sticky at a level
above the ECBs medium-term objective. The European Commission
(2002) interpreted this to be due to some extent to steady inationary
pressures in the services sectors. Since the service sector is the single
most important component of the euro HICPbasket, at a weight of close
to 40 percent, its precipitous rise put upward pressure on euro area core
ination and made it difcult for ination to work its way down.
5
3.3.2 Is the Below 2 Percent Ination Objective Too Low?
Figure 3.3 also brings us to the question of whether the ECB has been
too deationary. Is a maximum ination rate of 2 percent (even if it refers
to the medium term) too low? The following arguments have been put
forth in defense of setting a higher maximum rate of ination:
There can be an upward measurement bias in ination.
There is less risk of deation.
The Balassa-Samuelson effect calls for a higher ECB ination

objective.
It can create more room to stabilize the economy.
Ination tends to grease the economy.

We will briey summarize these arguments.
0
0.5
1
1.5
2
2.5
3
3.5
J
a
n
-
9
9
M
a
r
-
9
9
M
a
y
-
9
9
J
u
l
-
9
9
S
e
p
-
9
9
N
o
v
-
9
9
J
a
n
-
0
0
M
a
r
-
0
0
M
a
y
-
0
0
J
u
l
-
0
0
S
e
p
-
0
0
N
o
v
-
0
0
J
a
n
-
0
1
M
a
r
-
0
1
M
a
y
-
0
1
J
u
l
-
0
1
S
e
p
-
0
1
N
o
v
-
0
1
J
a
n
-
0
2
M
a
r
-
0
2
M
a
y
-
0
2
J
u
l
-
0
2
HICP
HICP excluding energy and
unprocessed food

Figure 3.3
Ination in the euro area, 1999 to 2002. (Source: Data provided by De Nederlandsche
Bank)
40 Chapter 3
It has long been recognized that due to measurement bias, measured
ination is likely to overstate actual ination. As pointed out by Sibert
(2003), there are several reasons for this. First, price indexes are calcu-
lated by comparing the price of a basket of goods consumed in a base
year with the price of the same basket consumed in the current year.
This overstates ination because it does not take into account that con-
sumers may substitute goods if prices rise. Second, improvements in
the quality of goods may cause price changes to be overestimated. The
quality of goods typically increases over time, and this, for example,
makes computers bought at two different points in time not directly
comparable. Ignoring this quality change will induce a measurement
error in the price index. Third, prices of new goods often fall rapidly
in the rst few years right after their introduction. It may even be
several years before goods are included in the basket of goods used to
calculate the price index, and thus the fall in their prices may be missed.
An important problem in handling new goods is also that there is no
price in the base year that can serve as a reference. Finally there may
be an outlet bias resulting from shifts in market shares among retailers
that are not reected in the composition of the sample outlets used in
the survey.
The publication of the so-called Boskin Report in 1996 gave a new
impetus to this issue. The Boskin-commission concluded that the
US CPI had been overstating the annual rise in the cost of living
(COL) by about 1.1 percentage points. A recent study by Lebow and
Rudd (2003) concludes that the size of the upward measurement
bias is about 0.9 percentage points for the United States, with a
plausible range of about 0.3 to 1.4 percentage points. These measure-
ment problems led Alan Greenspan to conclude that a specic
numeric ination target for monetary policy would be unhelpful and
misrepresentative.
6
In contrast, the Governing Council of the ECB believes that the
quality of the HICP makes it possible to provide a precise denition of
price stability in the euro area (Issing 2001b). There are no broad studies
of the accuracy of European consumer price indexes comparable
to those conducted in the United States by the Boskin commission.
As pointed out by Wynne and Rodrguez-Panzuela (2002), after the
appearance of the Boskin Report, several studies were conducted
within European countries to assess mis-measurements in their
national CPIs. The conclusions differed across countries, but they rein-
forced those of the Boskin commission, though with effects that were
generally smaller than for the United States.
7
Putting a precise number
on the degree of measurement error in the HICP is premature, accord-
ing to Wynne and Rodrguez-Panzuela (2002). Despite the growth in
the number of products that was studied for possible measurement
error, there was still not enough information for setting a point esti-
mate. Interestingly, at a recent ECB-CEPR workshop on this topic,
evidence was presented that suggests the measurement bias for cer-
tain items to be downward and not upward, contrary to the widely
held belief that measurement errors always overstate the true rate of
ination (see Camba-Mendez et al. 2002).
If the measurement bias in the euro were the same as in the United
States, an ination objective of close to 2 percent would be sufcient
to prevent deation in the euro area. This is important because dea-
tion may be very harmful (see Buiter 2003; Sibert 2003).
8
Deation
involves many of the costs of ination. First, there are the menu costs
associated with changing prices that occur whether prices go up or
down. Second, like ination, deation exacerbates the distortions
inherent in tax and benet systems considerably (Feldstein 1999).
Third, unanticipated price changes redistribute wealth. Ination redis-
tributes it from creditors to debtors; deation redistributes it from
debtors to creditors. Sibert (2003) argues that the redistribution due to
unexpected deation may be more costly than the redistribution due
to unanticipated ination. Defaults may occur, and the resulting bank-
ruptcies and restructurings destroy real wealth. The deterioration
in debtors balance sheets brought about by unexpected deation can
thus lower both consumption and investment demand. According to
Mishkin (1997), deation has been a key factor in the promotion of
nancial instability in industrial countries. In the case of persistent
deation, there is the risk of a deationary spiral of falling prices,
output, prots, and employment. Aggregate demand-induced dea-
tion can cause unemployment if nominal wages are downward rigid.
With sticky wages, as prices decline, real wages rise, prot margins fall,
and employment is cut back. A deationary cycle is set off. Akerlof
et al. (1996) show that at an annual rate of deation of 1 percent and
downward rigidities in nominal wages, unemployment in the United
States could rise from a long-run equilibrium rate of 5.8 percent to 10.0
percent (see below for a discussion of how ination can grease the
economy).
It should be obvious that it is better to prevent deation than to try
to cure it. Even if the ination objective of close to 2 percent is high
42 Chapter 3
enough for the euro area as a whole to avoid deation, deation can
still occur in a member state, depending on how large the ination dif-
ferentials are in the Union. If signicant ination differentials within
the euro area should occur, some countries would experience deation,
whereas the euro area as a whole would not. In fact, according to the
International Monetary Fund the risk of a mild deation in Germany
is considerable (see Kumar et al. 2003).
Ination differentials could be due to both temporary and structural
factors. Temporary factors include differences in national scal policies,
differences in pass-through patterns of external price and costs
shocks (see section 3.6.1), and different cyclical positions of the various
economies (see section 5.4). Temporary ination differentials in a mon-
etary union do not pose a real problem for monetary policy making. A
structural factor could be the Balassa-Samuelson effect. Due to higher
productivity growth the countries catching up will have a structural
higher rate of increase of prices than more advanced countries. The dif-
ferentials in sectoral productivity growth that result from the process
of catching up and convergence of living standards across countries are
an equilibrium phenomenon that does not require corrective policy
actions. However, if substantial ination differentials exist due to the
Balassa-Samuelson effect, a stable aggregate price level for all countries
taken together, may mean a deation in the more advanced countries.
Likewise a constant price level in the more advanced countries may
mean ination in the aggregate. According to Sinn and Reutter (2001),
the ination differentials resulting from the Balassa-Samuelson effect
suggest the need for a reconsideration of the close to 2 percent ina-
tion objective announced by the ECB (see section 5.5 for a further
discussion of ination differentials in the euro area). These authors
argue that the ECB should tolerate a substantially higher ination rate
in Europe than the Bundesbank aimed for in Germany. In their
words (Sinn and Reutter, 2001, p. 2):
Euroland is bigger and more diverse than Germany, and for the time being sub-
stantial relative price changes have to be accounted for. These relative price
changes require an ination rate for Euroland that is higher than the one
appropriate for any single European country if the risk of local deation is to
be avoided. If, say, Ireland needs a price increase relative to Germany, then it
makes little sense to prescribe Germanys previous idea of price stability to the
average European price index, because it might require deation for Germany
or at least a dangerously low ination rate. Thus, the Bundesbanks goals
should not be taken over by the ECB on a one-to-one basis.
This conclusion crucially depends on how important the Balassa-
Samuelson effect is in the euro area. As we will show in section 5.5,
there is little consensus in the literature on this issue. Furthermore, as
pointed out by the ECB (2003b), the size of the Balassa-Samuelson effect
for countries currently in the euro area is likely to diminish in the
future, given that there has been substantial convergence among
countries in terms of per-capita GDP. It may be more important for
the acceding countries (see section 6.3).
As for the fourth argument, Summers (1991) frames it as follows:
since nominal interest rates cannot fall below zero, monetary policy faces
a trade-off between a very low level of ination and stabilizing the economy.
If the economy is faced with a recession when ination is zero, the mon-
etary authority is constrained in its ability to engineer a negative short-
term real interest rate to counter the output loss. This constraint reects
the fact that the nominal short-term interest rate cannot be lowered
below zero, the so-called zero interest rate bound.
9
The zero bound con-
straint renders the risks of deviating from an ination rate of zero
asymmetric. As Alan Greenspan has noted, . . . deation can be detri-
mental for reasons that go beyond those that are also associated with
ination. Nominal interest rates are bounded at zero, hence deation
raises the possibility of potentially signicant increases in real interest
rates.
10
Japan is often mentioned as an example of a country where this
problem has occurred. Krugman (1998) and Svensson (2000) have
warned the United States may experience the same situation. Several
studies have tried with small macro models to assess the likelihood of
nominal interest rates hitting the zero lower bound for various levels
of ination objectives. While results in this area are highly uncertain
and depend on a number of specic assumptions, most available
studies indicate that the likelihood decreases to very low levels when
the objective of the central bank is set at an ination rate above 1
percent.
11
Coenen et al. (2003) nd that if the economy is subject to stochastic
shocks similar in magnitude to those experienced in the United States
over the 1980s and 1990s, the consequences of the zero bound are
negligible for target ination rates as low as 2 percent. The effects of
the constraint are nonlinear with respect to the ination target and
produce a quantitatively signicant deterioration of the performance
of the economy with targets between 0 and 1 percent. This conclusion
44 Chapter 3
is based on stochastic simulations of a small structural rational
expectations model, with monetary policy modeled as a Taylor type of
interest rule.
Reifschneider and Williams (2000) show that the zero bound can con-
strain policy in cases of very low ination where the policy is based on
the Taylor rule. Their simulations show that the nominal funds rate can
become stuck at zero over 10 percent of the time. Nevertheless, a large
reduction in the unfavorable effects of the zero bound can be realized
by a simple modication to the Taylor rule, by incorporating a response
to past constraints on policy.
Vials (2001) has compared the chances of the euro area hitting the
zero lower bound with those of the United States. His results suggest
that the euro area faces a smaller chance of hitting the zero lower bound
because of its structural characteristics.
Even if the zero bound were hit, monetary policy would not be
impaired because there are other mechanisms by which monetary
policy operates in the economy. First, as Krugman (1998) emphasizes,
there is the importance of lifting expected ination to lower the market
real interest rate at the zero lower bound. In announcing an ination
target in a deationary environment, the central bank can raise ina-
tionary expectations, but the central bank cannot force higher expected
ination.
12
Second, as Meltzer (2001) and others have argued, trans-
mission mechanisms other than the nominal interest rate are effective
at the zero lower bound. Bernanke and Gertler (1995), for example,
show that the credit channel mechanism is not hampered by a lower
zero bound on interest rates. Third, as Buiter and Panigirtzoglou (1999)
and Goodfriend (2000) have proposed, a carry tax on money (both cur-
rency and bank reserves) can be introduced to circumvent the interest
oor. The possible success of this suggestion depends on the availabil-
ity of technologies that make it feasible without high costs. Fourth, as
Svensson (2001) has shown, several approaches might be combined to
escape the liquidity trap if and when, as Ullersma (2002) argues, the
central bank can devaluate the exchange rate of the domestic currency
without limit.
Akerlof et al. (1996, 2000) argue, for different reasons, that a moder-
ate level of ination provides grease to the price and wage setting process.
13
The economic adjustment of relative prices to shocks can become slug-
gish in the presence of downward nominal rigidities in wages and
prices. For instance, at a zero ination rate, individual rms facing an
adverse rm-specic shock will not be able to secure real wage reduc-
tions in the presence of downward nominal wage rigidity, so they will,
instead, lay off workers. Likewise, at low levels of ination, a signi-
cant part of the price and wage setters may ignore or underweigh antic-
ipated ination in setting future prices. A moderate level of ination
provides for some real wage exibility, which reduces the natural, or
long-run, rate of unemployment.
14
Akerlof et al. conclude that large permanent reductions in unem-
ployment can be obtained by moving from either a very high or very
low rate of ination to a moderate rate, which they estimate for the
United States to be 2 to 4 percent. However, Gordon (1996) argues that
the prediction that a lower rate of ination would imply a higher per-
manent level of equilibrium unemployment is not conrmed by the
recent historical evidence of the United States, nor by cross-country
analysis of the relationship between ination and unemployment.
Furthermore there may also be a sand effect on the natural rate of
unemployment. When ination rises, money illusion dissipates and the
burden of price uncertainty rises (Groshen and Schweitzer 1999). So the
long-run Phillips-curve is not vertical; the natural rate increases with
ination and not necessarily monotonously. As pointed out by Wyplosz
(2001), the grease and sand effects are not mutually exclusive: at very
low levels of ination the grease will dominate, and the sand will set
in only when ination becomes more variable. Wyplosz (2001) exam-
ines the relationship between steady state unemployment and ination
in four European countries: France, Germany, the Netherlands, and
Switzerland. He concludes that there is evidence for the grease effect
to increase the natural rate of unemployment by some to 2 to 4 per-
centage points in the middle of the ECBs ination target range. To
reduce that effect, the ECB should aim at an ination rate of more than
5 percent.
15
According to the ECB (2003b), however, the empirical evidence on
the importance of downward nominal rigidities for the euro area is not
conclusive. From the distribution of changes in the euro area price
indexes, nominal price cuts do not appear to be as uncommon as often
believed. For instance, the fraction of the euro area HICP that displayed
negative year-on-year price changes in March 2002 was 11 percent. At
the time ination was 2.5 percent. In December 1998, when ination
stood at 0.8 percent, 20 percent of all categories exhibited negative price
changes (Kieler 2003).
46 Chapter 3
In regard to wage-setting behavior, most studies have found a
concentration of wage changes around the zero mark. Yet micro-based
studies show a substantial proportion of wage earners to have experi-
enced wage cuts. Beissinger and Knoppik (2001) document in their
panel data, for example, that a large portion of wage cuts in Germany
affected up to 20 to 30 percent of the blue-collar workers. Similarly,
using the German socioeconomic panel data, Decressin and Decressin
(2002) nd that about one-fth of the workers retaining their jobs expe-
rienced nominal cuts in wages. In these cases the level of ination
affected the distribution of real wage changes. Decressin and Decressin
conclude that the results for Germany, which has experienced ina-
tion at about 2 percent per year on average over the 1990s, suggest that
insufcient wage exibility does not make a compelling case for
the ECB to adopt a higher ination target. Nonetheless, some sand
thwarts the functioning of the wage setting mechanism in Germany.
. . . Specically, the presence of a nominal rigidity at the zero mark
for base wages suggests that pushing ination much below 2 percent
could bear risks (p. 30). In contrast, using German micro data (IBA-
Beschftigtenstichprobe), Knoppik and Beissinger (2003) report a high
degree of downward nominal wage rigidity. They show that a very low
ination policy can have expensive side effects. The high downward
nominal wage rigidity is detrimental for individual expected wage
growth, the aggregate wage level, and equilibrium unemployment
when ination rates are lower than 3 percent. When ination rates are
above 4 percent, these effects are negligible.
At the macro level the presence of downward nominal rigidities has
been usually associated with nonlinearities in the Phillips curve at low
ination (Ball et al. 1988). Downward nominal wage rigidities can give
rise to nonlinearities in the Phillips curve at near-zero ination. Because
a larger fraction of workers is bound by the downward rigidity, the
aggregate wage responds less to a negative shock to labor demand than
to a positive shock of equal magnitude. The slope of the Phillips curve
also becomes atter at ination rates close to zero, implying that a
larger change in unemployment is needed to produce a certain change
in wage ination. Although there is some evidence for nonlinearities,
there are as many ndings to the contrary (see Kieler 2003 for a dis-
cussion). However, because of the lack of prolonged periods of very
low ination, the analysis of this issue is considerably clouded by the
scarcity of evidence. It should additionally be noted that a positive
trend in productivity growth permits rms to reduce labor costs per
unit of output without necessarily cutting nominal wages. Finally, even
if downward nominal rigidities were pervasive, there remains the
question whether accommodating them with a higher ination rate
makes this undesirable structural feature of some economies not even
more entrenched (ECB 2003a).
Coenen (2003) investigates the importance of the existence of down-
ward nominal wage rigidity, using stochastic simulations of a small
estimated model of the euro area in which wage contracts are stag-
gered. To establish downward nominal wage rigidity, it is assumed that
the changes in the nominal wage contracts are nonnegative. Further-
more, monetary policy makers are assumed to follow a standard Taylor
rule. The results suggest that the asymmetry of wage adjustments
causes a nonvertical long-run Phillips curve in which output falls
increasingly short of potential with lower ination targets. The output
loss, which depends on the degree of ination persistence, is in the
order of one-eighths to one-fourths of a percentage point even when
the ination target is set at zero.
3.4 Role of the First Pillar
Jaeger (2003) argues that initial ECB comments on its strategy sug-
gested that the rst pillar would not only be the prominent but provide
the dominant input into policy decisions. When ECB President Duisen-
berg was asked on the relative importance of the two pillars, he noted
that . . . it is not a coincidence that I have used the words that money
will play a prominent role. So if you call it the two pillars, one pillar is
thicker than the other is, or stronger than the other, but how much I
couldnt tell you. With M3 growth persistently exceeding its reference
value, increasing stress was put on the need to undertake a compre-
hensive monetary analysis that goes beyond a comparison between
M3 growth and the reference value.
The rst pillar in the monetary policy strategy of the ECB has been
severely criticized. One reason why the use of money growth has been
criticized is that the outcome of the analysis of the monetary analysis
is often at odds with the results of the economic analysis.
16
No doubt,
this is true for more recent years. However, in the early years of the
ECB this conict was not apparent. Table 3.3 summarizes the main
comments of the president of the ECB referring to the growth rate of
M3 and its components when he explained the ECBs monetary policy
decisions in the years 1999 to 2001. It also shows the actual decision.
48 Chapter 3
Table 3.3
Role of M3 growth in monetary policy decisions of the ECB, 19992001
Council meeting Statements on M3 growth
December 22, Latest three-month moving average annual growth rate of M3
1998 (no change) stood at 4.5%. This was exactly in line with the reference value set
by the Governing Council. Actual situation, characterized by
monetary growth compatible with continued price stability
justies maintaining the current stance of monetary policy.
January 7, 1999 The 12-month growth rate of M3 decreased from 5% in October to
(no change) 4.5% in November 1998. The latest three-month moving average of
M3 growth was approximately 4.7% and has remained close to the
reference value. The Council has not altered its assessment
regarding the outlook for price developments.
February 4, 1999 Council conrmed its earlier assessment that the outlook for price
(no change) stability remains favorable. Latest 3-month moving average of
annual M3 growth was 4.7% and has remained very close to the
reference value.
March 4, 1999 As monthly data on monetary aggregates can be volatile, M3
(no change) growth is monitored on the basis of three-month moving average
of the 12-month growth rate of M3, which stood at 4.9%. In view
of the uncertainty relating to special factors pertaining to the
changeover to stage 3, the Council does not consider the
acceleration as a signal of future inationary pressures. However,
close monitoring remains necessary to give more conclusive
evidence of the underlying causes and the permanent or
temporary nature of the rise in M3 growth.
April 8, 1999 The 12-month growth rate of M3 declined from 5.6% in January to
(reduction 50 5.2% in February, largely reecting a slowdown in growth of
basis points) overnight deposits. Three-month moving average increased by 0.2
percentage point to 5.1%. The Council does not regard current
monetary trends as constituting a signal of future inationary
pressures as it is still close to the reference value and considering
that it may to some extent mirror the specic environment related
to the start of stage 3.
May 6, 1999 (no Monetary developments do not signal dangers to price stability
change) over the short and medium term. The 12-month rate of growth of
M3 remained at 5.1%. The latest gure for the 3-month moving
average was 5.2%, which was 0.2 percentage points higher. Trends
should not be seen as warning signal with regard to future
evolution of ination given special circumstances and the fact that
growth remains relatively close to reference value.
June 2, 1999 (no Twelve-month growth rate of M3 decreased from 5.2 to 4.9% in
change) April, mainly due to decline in short-term deposits. Three-month
moving average fell to 5.0 from 5.3%. Current monetary
developments are in line with price stability over the medium
term.
Table 3.3
(continued)
July 15, 1999 (no Three-month moving average of M3 growth increased slightly to
change) 5.2%. Major contribution came from overnight deposits. Annual
growth rate of total credit rose from 7.3 to 7.9% in May. Growth of
loans to private sector rose to 10%. Situation not seen as
threatening price stability, but reassessment may be appropriate if
money and credit growth increase further.
September 9, Twelve-month growth rate increased from 5.6 to 5.3%. Latest
1999 (no change) three-month average rose from 5.3 to 5.4%. Growth rate has been
moving away from reference value. Upward trend may be
explained by very low opportunity costs of holding monetary
assets but perhaps also by gradually improving economic
conditions. Annual growth rate of credit to private sector
remained high, although it declined to 10.4%.
October 7, 1999 Three-month growth rate increased to 5.6% from 5.5%. Twelve-
(no change) month growth rate displayed upward trend during 1999. Credit to
private sector expanded at 10.7%. On balance, monetary conditions
signal rather generous liquidity situation in the euro area.
November 4, Main argument for increase of rates by 50 basis points was that
1999 (increase 50 balance of risks for price stability has gradually moved to the
basis points) upside. Several indicators, including monetary growth, suggest
that there is ample liquidity in the euro area. M3 growth is on
rising trend. Three-month growth rate is 5.9%. Strong growth of
most liquid components of M3 is noteworthy, suggesting that low
interest rates favored strong growth of money. The pickup in
economic activity is likely to have further stimulated M3 growth.
Credit to private sector remained strong expanding at rate above
10%.
December 2, Data conrmed picture of generous liquidity situation. Annual
1999 (no change) growth rate of M3 in October was 6%, compared to 6.2% in
previous month. Three-month average was unchanged at 6%.
Growth of most liquid components of M3 remained very dynamic.
Annual growth rate of credit to private sector continued to exceed
10%. Developments are driven by low level of interest rates and
pick-up of economic activity.
January 5, 2000 Three-month growth rate of M3 was 6%. Current liquidity
(no change) conditions continue to be generous. This is conrmed by
continued strong growth of loans to the private sector (10.1% in
November compared to 9.9% in October).
February 3, 2000 Both monetary and credit growth continue to signal generous
(increase 25 liquidity conditions. Monetary growth has been consistently above
basis points) reference value and credit growth to the private sector is
continuing to grow at more than 10%. Three-month average
growth rate rose to 6.1%. At 10.5% annual growth rate of credit to
the private sector continued to be high. Monetary and credit
developments remain important factors contributing to upside risk
to price stability.
50 Chapter 3
Table 3.3
(continued)
March 2, 2000 Three-month growth was 5.7 compared with 6% in last quarter.
(no change) Reduction was determined by a base effect as monthly increase in
January 1999 was exceptionally strong. Private sector credit
growth remained high at 9.5%. Overall prolonged deviation from
reference value and dynamic credit growth indicate that liquidity
conditions remain generous.
March 16, 2000 Prolonged deviation of M3 growth from reference value points to
(increase 25 existence of ample liquidity, especially when seen in conjunction
basis points) with continued strong growth of credit to the private sector.
March 30, 2000 Annual growth rate of M3 was 6.2%, implying a small increase in
(no change) three-month moving average growth rate.
April 13, 2000 Annual growth of M3 was 6.2%, which implied small increase in
(no change) 3-month moving average to 5.9% from 5.8%. Picture of generous
liquidity conditions is conrmed by strong annual growth of loans
to private sector at 10.5%.
May 11, 2000 Three-month moving average rose to 6% from 5.9%. Annual
(no change) increase in credit to the private sector rose to 10.9 from 10.4%.
These gures conrm earlier assessment that liquidity continued
to be ample in the euro area in early 2000.
June 8, 2000 Strong growth of money and credit throughout 1999 and the
(increase 50 pronounced expansion of money and credit aggregates over the
basis points) rst four months of 2000 have strengthened the view that liquidity
conditions are ample. Three-month moving average growth rate of
M3 was 6.3%. Expansion of credit to the private sector exceeded
11% in April 2000.
July 6, 2000 (no Three-month moving average stood at 6.3%, unchanged, but
change) substantially above reference value. This, combined with the
strong growth of both M1 and credit to the private sector,
indicates that liquidity conditions continued to be ample in the
euro are through May. Increase in interest rates of June exerts
moderating inuence on money and credit growth.
August 31, 2000 Although measures taken since November 1999 are gradually
(increase 25 feeding their way through, latest available information indicates
basis points) that M3 growth has continued to deviate on the upside from the
reference value. At the same time the expansion of credit to the
private sector suggests that households and rms regard nancing
in the euro area as being very favorable. In the context of the
robust expansion of economic activity, a continuation of ample
liquidity conditions would constitute a risk to price stability.
Table 3.3
(continued)
September 14, M3 growth has been showing some signs of moderation over
2000 (no change) recent months, mainly as consequence of lower growth in the
most liquid components of M3, which bear little or no
remuneration, indicating that the policy measures taken since
November 1999 are gradually feeding their way through. At the
same time growth of M3 at 5.5 continued to deviate on the upside
from the reference value. Pronounced expansion of credit to the
private sector suggest that households and rms continue to
regard nancing conditions as favorable, which constitutes a risk
to price stability.
October 5, 2000 M3 growth declined to 5.3% from 5.5%. German UMTS auction
(increase 25 appeared to have a temporary upward impact on M3 growth.
basis points) Short-term developments in monetary aggregates seem therefore
to be more moderate than August data would suggest. Still,
liquidity conditions continue to be ample given protracted
deviation of M3 growth from reference value, coupled with still
relatively high growth of loans to private sector.
November 2, M3 growth stood unchanged at 5.4% While remaining above
2000 (no change) reference value, M3 growth has shown signs of moderation.
Growth rate of credit to private sector increased to 10.8%, but this
was inuenced by nancing of UMTS licenses. Growth rate of MFI
credit to euro area residents remained broadly unchanged.
December 14, M3 growth rates have shown signs of moderation over the past
2000 (no change) few months. However, taking into account protracted upward
deviation from reference value and still robust growth of growth
of credit to private sector, caution continues to be warranted with
regard to upside risks to price stability.
February 1, 2001 M3 growth was slightly lower at 5.0%. Therefore, after recent
(no change) slowdown in monetary growth, the risks to price stability from the
monetary side have become increasingly balanced. Caution still
needs to be exercised, however, given the continued dynamics in
credit growth to the private sector and the upward deviation of
M3 form the reference value in the past.
March 1, 2001 Moderation of the growth of monetary aggregates continued.
(no change) Three-month average of M3 growth stood at 5.0%, which was
slightly lower.
April 11, 2001 M3 growth has been on gradual downward trend since spring
(no change) 2000. Growth rate reached 4.8%. Growth in credit aggregates has
also been less buoyant over the past few months. All in all,
information from the rst pillar is signaling that upwards risks to
price stability have diminished over the past few months.
52 Chapter 3
Table 3.3
(continued)
May 10, 2001 M3 growth has been on gradual downward trend since spring
(decrease 25 2000. Growth rate stood at 4.8%, close to reference value.
basis points) Slowdown in credit aggregates has also been visible in past few
months. In addition there have been indications that the monetary
aggregates are distorted upward by noneuro area residents
purchases of negotiable paper included in M3. Distortion has
become more sizable over recent months and amounts to half a
percentage point. There is an additional distortion due to
nonresidents holdings of other marketable paper included in M3.
Taking into account these upward distortions, as well as all
information from the rst pillar, it can be concluded that there is
no longer a risk to price stability over the medium term
emanating from the rst pillar.
June 7, 2001 (no M3 growth has been on gradual downward trend since spring
change) 2000, driven predominantly by its most liquid components. M3
growth has stabilized. M3 adjusted stood at 4.6%. Growth rate of
loans to the private sector continued to moderate over recent
months.
July 5, 2001 (no M3 adjusted stood at 4.9%. As indicated earlier, M3 is currently
change) distorted by holdings of money market paper and short-term debt
securities of noneuro area residents. As a result three-month
moving average was broadly in line with reference value. In
addition growth of credit continued to be moderate.
August 30, 2001 Three-month average growth of M3 was 5.9%, but this gure
(decrease 25 needs to be corrected for holdings of money market paper and
basis points) short-term debt securities by nonresidents of the euro area, which
according to preliminary estimates have contributed around three-
quarters of a percentage point to annual M3 growth. Increase of
M3 growth reects relatively at yield curve and recent weakness
in stock markets which make holdings of short-term assets
attractive. Growth may be transitory and does not necessarily
have implications for price stability in the medium term. Loans to
private sector declined over recent months.
October 11, 2001 Strong increase in M3 growth over the past few months. However,
(no change) a number of temporary factors play an important role (at yield
curve and uncertainty in stock markets). Furthermore growth of
credit to private sector continued to slowdown. Therefore
monetary developments do not signal risks to price stability at this
juncture.
November 8, M3 growth increased further in September but needs to be seen as
2001 (reduction reection of an increased preference of investors. In addition
50 basis points) growth of credit to private sector has continued to decline over
recent months. Overall, current monetary developments do not
signal risks to price stability in the medium term.
Table 3.3
(continued)
December 6, M3 growth rose to 6.8%, signicantly above reference value.
2001 (no change) Investors have shifted their portfolio toward liquid and relatively
safe short-term assets included in M3. Such shifts should be
temporary and not indicating future inationary pressures.
Assessment underpinned by the fact that credit growth to private
sector has been continuously falling over recent months.
In 1999 the developments in the rst pillar were broadly in line with
decisions taken. In April the twelve-month growth rate of M3 declined,
and the three-month moving average growth rate was close to the ref-
erence value.
17
In November the opposite pattern can be discerned.
Apart from these growth rates of M3, the ECB also often referred to the
growth rate of credit to the private sector when it reported on devel-
opments under the rst pillar.
Basically the same pattern emerged for the interest rate increases in
the rst half of 2000. M3 growth remained substantially above the ref-
erence value and increased. This situation, in conjunction with the high
growth rate of credit to the private sector, contributed to the decisions
taken by the Governing Council. In the latter part of 2000 the situation
became less clear-cut. Although M3 growth remained above the refer-
ence value, it started to decline. This is, of course, the kind of situation
where the decision-making process is the most difcult. Nevertheless,
given that M3 growth was still substantially above the level that the
ECB considers consistent with price stability and that the growth rate
of credit to the private sector was still very high, the increase in inter-
est rates in October 2000 should not be a real surprise.
In 2001 M3 growth declined further, getting close to the reference
value. So from this perspective the cut in interest rates in May 2001 was
in line with this development. Still there was quite some confusion,
mainly caused by the statements about the distortion of M3 growth due
to the holdings of assets by non-euro area residents. This caused the
impression that the ECB was looking for some kind of argument to
ensure that developments under the rst pillar were in line with the
decision taken. Careful reading of the previous announcements of
Duisenberg shows that the ECB had announced a number of times
before that M3 growth was on a downward trend. The decision to cut
interest rates further in August and November 2001 was harder to
54 Chapter 3
understand from this perspective, as M3 growth was increasing again.
According to the ECB this was not worrisome, given the distortions
that were estimated to be three-quarters of a percentage point, and
temporary factors. During this period it is easy to understand why
observers started to talk about smokescreens when referring to the rst
pillar. And in more recent periods it became questionable whether
money should play a separate role in the monetary policy strategy of
the ECB.
Obviously a target that is specied in terms of the nal objective is
more comprehensible than a target with an uncertain relation to the
ultimate objective. Hence it is a more effective communication device
between the ECB and the public (Cukierman 2001a). Still, according to
the ECB, there are arguments in favor of maintaining the M3 reference
value (Angeloni et al. 1999).
First, since in the long run money is a major, if not the most impor-
tant, determinant of ination, it is reasonable to take ination into
account in deciding about monetary policy. Although the long-run cor-
relation between money growth and ination in historical data is high,
the correlation for shorter horizons of around one to three years is more
relevant for monetary policy purposes. This correlation is much lower
than the long-run correlation. In the short run real money growth is
more variable, causing a relatively low short-run correlation between
nominal money growth and ination. This low correlation in the short
run throws considerable doubt on the use by the ECB of the money
growth indicator, namely M3 growth relative to the reference value.
According to the ECB, substantial or long-lasting deviations of mone-
tary growth from the reference value could signal risks to medium-
term price stability under normal circumstances. However, the growth
rate of money in the euro area has signaled an acceleration of the ina-
tion rate for many years, although ination has not increased.
Second, given the uncertainty about the transmission mechanism
of monetary policy decisions, it may be better not to discard money
growth. However, this is not a reason why money should be given a
prominent role; monetary developments could be taken into account
in the second pillar.
Finally, since the Bundesbank, which is generally regarded as highly
credible (see chapter 5), announced targets for M3 growth for many
years, the continuation of this practice may help the ECB to inherit
some of the credibility of its predecessor. However, the German central
bank missed its money growth targets more often than it hit them. Fur-
thermore the ECB has not literally followed the German practice of
monetary targeting. As was pointed out before, the ECB analyzes the
relationship between actual money growth and the pre-announced
reference value. To the extent that deviations of money growth from
the reference value indicate a threat to price stability, they will lead to
a monetary policy response. The ECB never used the term intermedi-
ate target, but employs the term reference value to indicate that it does
not change its interest rates in a mechanistic fashion.
What are the conditions to be met when the money stock is to be
used as an intermediate target of monetary policy? First, the money
stock must serve as a leading indicator for the ination rate. Second,
with its operating target(s) the central bank should be able to control
the money stock. Finally, the demand for money must be sufciently
stable. The euro area money demand function is relatively stable in
comparison with the demand for money in other economies such as
those of the United States, the United Kingdom, and Japan. Calza
and Sousa (2003) give some explanations for this. First, country-
specic factors have inuenced money demand in other economies.
Second, the effect of nancial innovation on money demand has been
weaker in the euro area. Finally, aggregating data across countries is
benecial for the stability of the euro area money demand. It is
expected that these aggregation gains will remain because the cross-
country differences will always be present. In the future money
demand stability could decrease in the euro area if the share of wealth
held in nancial assets increases, because in that case portfolio shifts to
and from bond and stock mutual funds would increase.
The stability of the demand for money is necessary but not sufcient
for monetary targeting. If the operating targets of the ECB do not have
a systematic inuence on the money growth rates, monetary targeting
becomes inapplicable. This problem is thought to exist because the
money stock has shown little reaction to changes in the short-term
nominal interest rates in the euro area (Bonger 1999).
Rudebusch and Svensson (2002) show that money growth targeting
to stabilize money growth in the euro area would be a very bad mon-
etary strategy. This is because it can cause very high variability of both
ination and the output gap. Current ination and the output gap are
much better predictors of future ination at horizons of interest to
monetary policy.
56 Chapter 3
In conclusion, we feel that the ECB should abandon the monetary
analysis as a dominant navigation system for its monetary policy but
use the relevant information in the economic analysis.
3.5 Ination Forecasts
Most academic observers favor some kind of ination targeting. The
second pillar has been criticized because it is not a real ination-
targeting strategy. Initially the ECB was even reluctant to publish
ination forecasts. According to the European Monetary Institute
(EMI 1997, p. 16), the predecessor of the ECB,
. . . there are conceptual difculties in formulating forecasts conditioned on
unchanged policies since some nancial market indicators which provide input
to these forecasts are typically inuenced by the markets anticipated stance of
monetary policy over the forecasting horizon. Furthermore, there is a risk that
publishing ination forecasts may, at times, have adverse effects on nancial
markets and wage and price setting and that the credibility of the ESCB could
be damaged in the medium term if the conditional nature of the forecasts is
not well explained.
However, if the meaning of forecasts is properly communicated
which is not easypublication of the ination forecasts may help the
public understand and evaluate ECB policy decisions. It is important
that forecasts be properly explained, as they may otherwise become
self-fullling prophecies. Just publishing an ination forecast is not a
substitute for explaining the reasoning and assumptions underlying
monetary policy.
In December 2001 the ECB published for the rst time its so-called
projections. These projections are prepared by the staff of the Eurosys-
tem. They are conditional on the assumption of unchanged short-term
interest rates and are formulated in terms of ranges rather than point
values; there are no mean or modal values published. The results are
presented to the Governing Council for its meetings in June and
December. According to Issing (2001b), the projections provide a coun-
terfactual scenario that aims to facilitate the discussion in the Govern-
ing Council by pointing out the consequences of a lack of monetary
policy actions over the project horizon. Therefore the projections do not
represent the ultimate synthesis of the Governing Councils assessment
of the euro area inationary outlook. They are just one of the inputs for
the Governing Council in coming to a decision on the proper monetary
policy. In this respect, the situation is very different from the United
Kingdom, where the projections are made under the responsibility of
the Monetary Policy Committee of the Bank of England.
In our view it would be better if the two-pillar strategy of the ECB
were replaced by explicit ination targeting. Abroad assessment of all
relevant information variables regarding expected ination, including
broad and narrow money growth, is incorporated in an ination-
targeting strategy. According to Svensson (1999), there are three main
other characteristics of ination targeting. First, there exists an explicit
quantitative ination target. Second, policy decisions are based on con-
ditional ination forecasts. Finally, the strategy takes place in an insti-
tutional environment with a high degree of central bank accountability
and transparency (see chapter 4 for a further discussion).
3.6 External Value of the Euro
With the creation of the monetary union (most of) the EU economy has
become relatively closed like that of the United States. Most trade ows
consist of intra-EU trade. Most observers would therefore probably
agree with Eichengreen (1998) that under these circumstances, the
theory of optimum currency areas suggests that it is optimal to let
the euro oat.
Still, even if the euro oats vis--vis most other major currencies,
this does not imply a policy of benign neglect by the ECB. First, as
explained in chapter 2, the eurodollar exchange rate is one of the indi-
cators of future inationary developments in the monetary policy strat-
egy of the ECB. After the start of the monetary union, the eurodollar
exchange rate declined; in 2002 an upward movement started (see
gure 3.4). How important is the eurodollar exchange rate for ina-
tion in the euro area? This issue will be discussed in section 3.6.1.
A second reason why the ECB closely follows exchange rates is that
there is always a risk that actual exchange rates may be out of line with
fundamentals, whatever they may be. Indeed, the concerted inter-
vention of the ECB and other central banks in September 2000, was
according to an ECB press releasemotivated by the shared concern
about the potential implications of recent movements in the euro
exchange rate for the world economy. In November 2001 the ECB
intervened again, but now the central banks of the United States and
Japan did not join in. In section 3.6.2 the usefulness of this kind of inter-
ventions will be discussed.
58 Chapter 3
3.6.1 Why the ECB Cares about the EuroDollar Exchange Rate:
Pass-through to Ination
The ECB has at various occasions made it clear that it closely monitors
the eurodollar exchange rate mainly because the initial decline of the
euro since the start of EMU has affected ination in the euro area.
18
Table 3.4 presents some estimates of the effect of 10 percent deprecia-
tion of the euro on the ination rate in the euro area as summarized by
Wyplosz (2003a). By and large, the effect of a depreciation on HICP
ination is small and imprecisely known. However, the effect is far
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1
-
1
-
9
9
4
-
1
-
9
9
7
-
1
-
9
9
1
0
-
1
-
9
9
1
-
1
-
0
0
4
-
1
-
0
0
7
-
1
-
0
0
1
0
-
1
-
0
0
1
-
1
-
0
1
4
-
1
-
0
1
7
-
1
-
0
1
1
0
-
1
-
0
1
1
-
1
-
0
2
4
-
1
-
0
2
7
-
1
-
0
2
1
0
-
1
-
0
2
1
-
1
-
0
3
4
-
1
-
0
3
7
-
1
-
0
3
1
0
-
1
-
0
3
1
-
1
-
0
4
Figure 3.4
Dollareuro exchange rate, monthly data 1999 to 2003. (Source: http://research.
stlouisfed.org/fred2/series/EXUSEU/95)
Table 3.4
Estimates of the effects of a 10 percent depreciation of the euro on euro area ination
Effect on ination
Model/paper Price index Short run Medium run Long run
INSEE (Chaney, 2003) HICP 1% 0.4% 0.8%
Hfner and Schrder (2002) Import prices 4% 5.5% 6%
Campa and Gonzles HICP 0.45%
Mnguez (2002)
ECB-area wide model HICP 1.6%
(Fagan et al. 2001)
Source: Wyplosz (2003a).
Note: Short run is up to three months, medium run is from six to twelve months, and
long run is two years and more.
from negligible. The table also suggests that the effect on import prices
is much larger than on HICP. The remainder of this section reviews the
literature on the exchange rate pass-through (ERPT), meaning the degree
to which exchange rate changes are passed through in (domestic)
prices.
19
Goldberg and Knetter (1997) dene ERPT as the percentage change
of import prices (in local currency) resulting from a 1-percent change
in the exchange rate between the exporting and importing countries.
Firms may choose to pass exchange rate alterations fully into their
selling prices (complete ERPT). At the other extreme, rms may decide
to absorb the shock by reducing their prot margins, so the selling
prices will be unchanged (no ERPT). Incomplete ERPT may be caused
by market power (see Feenstra et al. 1993).
The relationship between exchange rates and prices is given by the
following equation:
(3.1)
In equation (3.1), p is the local currency import price, and Xis a measure
of the export costs. Z may include import demand-shifting factors, such
as competing prices or income, and E is the exchange rate (importers
currency per unit of exporter currency). Taking the logarithm of both
sides, yields the elasticity of ERPT with which g is referred to as the
pass-through coefcient.
Greater openness of the economy means more competition, and this
puts downward pressure on the ERPT (see McCarthy 1999). However,
according to Knetter (1993), the variations between industries are more
important than the variations between countries. The market structure
and trade restrictions differ across industries and inuence the degree
of ERPT. According to Feenstra et al. (1993), the ERPT will be one when
the market share of a rm is zero. When the market share increases, the
degree of ERPT will rst decrease and then increase. When the market
share is one the ERPT will be complete (g = 1). This theory is described
in gure 3.5.
20
The intuition behind gure 3.5 is the following: In a situation with
strong competition (i.e., many rms having low market shares) changes
in exchange rates are largely reected in prices, because rms have low
prot margins. When less competition is present, ERPT decreases
because prot margins are higher. Exchange rate changes are therefore
not necessary fully reected in price changes. Firms want to keep their
customers and therefore accept lower prots instead of increasing
p X E Z
t t t r
= + + + + a d g y e
1
.
60 Chapter 3
prices. When the market share is high, ERPT rises. Firms pass exchange
rate movements through to prices, instead of decreasing prots. This
is because the loss of customers is small when competition intensity is
low.
Corsetti and Dedola (2001) argue that incomplete ERPT may exist
because of the difference in distribution and transportation costs
between domestic markets and markets abroad. Even if imported
goods are perfect substitutes for the domestically produced goods, they
are not consumed in large amounts because their costs are higher than
the costs of domestic goods. Consequently a change in the exchange
rate will have a small effect on the consumer price index (a lower
degree of ERPT).
Another possibility is that the low degree of ERPT does not primar-
ily reect the stickiness of prices but optimal price discrimination.
Imported goods can be regarded as intermediate products for which
there are domestic substitutes available. So local producers can
combine intermediate goods with local goods to produce a nal
product for the consumers. While the price for consumers is deter-
mined in local prices, the intermediate imports are xed in the currency
of the producer of that intermediate good. The importer is able to
switch between the imported intermediate good and the locally pro-
duced alternative when the exchange rate changes (expenditure
switching effect). According to Devereux et al. (1999), there are still
many substitution possibilities with the domestically produced goods.
Dornbusch (1987) used industrial organization models to express the
relationship between exchange rate uctuations and the domestic price
level in terms of market concentration, import penetration, and the sub-
stitution possibilities of the imported and domestic products. The ERPT
0
0.2
0.4
0.6
0.8
1
0 0.2 0.4 0.6 0.8 1
Market share

E
R
P
T

e
l
a
s
t
i
c
i
t
y
Figure 3.5
Relationship between market share and ERPT-elasticity. (Source: Feenstra et al. 1993)
on domestic producer prices appears larger in industries that are
characterized by a lower degree of concentration and a lower degree
of import penetration. Pass-through is smaller in more segmented
economies, which can participate in price discrimination. Countries
with a larger import share should have a larger ERPT (see Goldberg
and Knetter 1997).
Most of the empirical literature on ERPT published in the 1980s
focuses on the degree of pass-through in the United States. The
growing importance of imperfect competition and strategic trade
theory stimulated researchers to estimate the degree of ERPT at the
level of industries. For instance, Feenstra et al. (1993) analyze the auto-
mobile industry and nd that the degree of ERPT varies substantially
between different importing and exporting countries.
The majority of the empirical studies about ERPT of the last twenty
years shows that ERPT is not complete. According to Goldberg and
Knetter (1997), the average degree of pass-through for the United States
Table 3.5
Exchange rate pass-through into import prices
Change in pass-through
Full sample pass-through elasticities, 1999 versus
elasticities 1989
Country Short run Long run Short run Long run
Austria 1.22
a
1.25 0.68 0.24
Belgium 0.16
b
0.71 1.02
a
0.18
Germany 0.59
a,b
0.79
a
-0.32 -0.12
Denmark 0.56
a,b
0.68
a
-0.42 -0.80
a
Spain 0.66
a,b
0.56
a,b
-0.40 -0.94
a
Finland 0.69
a,b
0.82
a
-0.15 -0.02
France 0.53
a,b
1.21
a
-0.82
a
-1.00
United Kingdom 0.39
a,b
0.47
a,b
0.11 0.11
Greece 0.40
b
-0.02
b
-0.61 -1.24
Ireland 0.79
a
1.37
a
-0.03 -1.17
Italy 0.67
a,b
0.62
a
-0.52 -0.65
Netherlands 0.75
a,b
0.77
a
-0.18 -0.17
Portugal 0.60
a,b
0.88
a
-0.04 -0.26
Sweden 0.67
a,b
0.59
a,b
-0.62
a
-0.45
Source: Campa and Goldberg (2002).
a. Signicantly different from zero at 5 percent level.
b. Signicantly different from one at 5 percent level.
62 Chapter 3
is 50 percent. For illustrative purposes, table 3.5 reproduces the results
of Campa and Goldberg (2002) for the EU countries in their sample. In
general, the ERPT is higher in the long run than in the short run, but
for all countries the ERPT is less than one both in the short and long
run. Note that there are huge differences across the countries of the
euro area. Campa and Goldberg (2002) compare the elasticities esti-
mated over the rst half of the sample, 1977 through 1989, with those
for the full sample. The last two columns of table 3.5 show the results
of this split sample approach. In only 3 of the 14 countries there was
an increase in ERPT. In most of the countries the long-run and short-
run ERPT decreased, but the decline in ERPT was signicant for only
3 of the 11 countries.
The monetary union may effect ERPT in Europe. It is likely that
the international role of the euro will become more important in the
medium and long run. This implies that the euro will be accepted more
often in international payments, in particular as a vehicle currency.
Table 3.6 shows the inuence of the currency of pricing on the ERPT
to the retailer and the consumer.
Devereux et al. (1999) consider that rms will always set their whole-
sales prices in their own currency, for sales to both the domestic and
foreign retailers. This has not changed by the introduction of the euro.
Table 3.6
Currency of pricing
Wholesale prices before and after the euro
Region of production Region of consumption Currency Pass-through to retailer
United States Europe US dollar Complete
Europe United States Euro Complete
Retail prices before the euro
Region of production Region of consumption Currency Pass-through to consumer
United States Europe US dollar Complete
Europe United States US dollar Zero
Retail prices after the euro
Region of production Region of consumption Currency Pass-through to consumer
United States Europe Euro Zero
Europe United States US dollar Zero
Source: Devereux et al. (1999).
In contrast, retailers can set the retail prices either in the consumers
currency or in the currency used by the rm. In the rst case, retailers
bear the exchange rate risk, while in the second case, the exchange rate
risk is passed through to the consumers. It is assumed that after the
introduction of the euro the European retailers set retail prices of
imported goods in euro instead of dollar terms (the euro becomes a
vehicle currency). Consequently the sensitivity of the European
consumer prices to uctuations in the exchange rate is reduced. So the
ERPT will then be lower.
Some recent studies have suggested that ERPT may inuence
optimal monetary policy rules. For instance, Corsetti and Pesenti (2002)
show that the degree of ERPT and exchange rate exposure in markets
at home and abroad are key elements determining the optimal mone-
tary rules. Economies with a high degree of ERPT should, ceteris
paribus, have a monetary policy focused on internal conditions.
We conclude that according to most empirical studies, ERPT is
incomplete in the short and in the long run for most countries, although
ERPT in the long run exceeds short run ERPT. Exchange rate move-
ments inuence prices more in countries with a larger degree of ERPT.
In countries with a high degree of ERPT exchange rate movements
therefore contain information as to future ination. Especially in the
long run, exchange rate movements can lead to price changes, so they
are important to predicting ination. The introduction of the euro has
probably reduced the ERPT to consumers because the European
retailer sets the retail prices of imported goods in euro terms instead
of dollar terms (the euro becomes a vehicle currency). This means that
the sensitivity of the European consumer prices to uctuations in the
exchange rate has been reduced. The importance of exchange rate
movements in predicting the level of ination in the euro area might
therefore decrease somewhat.
3.6.2 The EuroDollar Exchange Rate: Do Interventions Help?
At the ECBs initiative, the monetary authorities of Canada, Japan, the
United Kingdom, and the United States joined to buy euros on
September 22, 2000. According to Koen et al. (2001) a total of around 6
billion euro was probably bought, of which around 3 billion by the
ECB. Within a few hours the euro jumped from 85 to 90 US dollar cents.
It then settled around 88 dollar cents for about a week. However,
depreciation resumed and by mid-October the euro had dropped
below its previous lows.
64 Chapter 3
A subsequent round of unilateral interventions was undertaken in
early November 2000, spread over three trading days (November 3, 6,
and 9). This time only the national central banks of the Eurosystem
stepped in. According to Koen et al. (2001) the amount bought was
slightly less than in September. The euro reacted less markedly this
time. It depreciated anew until late November and then appreciated
for some time.
The bad performance of the euro after the start of the monetary union
was not expected. During most of the period after the start of EMU,
the European economy was in good shape; ination was relatively low,
production growth was rising, and consumer condence was high.
Indeed, most studies of the equilibrium value of the euro lead to the
conclusion that the euro was undervalued during 2000 to 2001 (see
table 3.7). Various papers have tried to link the eurodollar exchange
rate to news about recent developments in order to explain the unex-
pected weakness of the euro, but with little success (see sidebar 4).
The Eurosystem can intervene either multilaterally or bilaterally.
Unlike the United States and Japan, the Eurosystem does not have to
wait for specic governmental instructions if it wants to intervene. An
unannounced intervention may counteract market feelings as existing
at the time, that the euro was a one-way bet (Koen et al. 2001).
However, many academics doubt whether sterilized interventions at
foreign exchange markets by central banks are very effective. However,
in his testimony to the US Senate Bergsten (2002) argues:
There are of course those who doubt the effectiveness of sterilized intervention
in the currency markets. Such a view ignores the fact that all three cases of
intervention by the Rubin-Summers Treasury worked in textbook fashion. Joint
USJapan intervention stopped and reversed the excessive strengthening of the
yen in 1995. Similar intervention stopped and sharply reversed the excessive
weakening of the yen in 1998. Joint USEU intervention in late 2000 stopped
the slide of the euro and prompted a 10 percent rebound.
Whether or not ofcial exchange intervention is effective in inuenc-
ing exchange rates is of crucial policy importance. There is a vast lit-
erature on this topic. In this section we review the recent literature on
(sterilized) foreign exchange interventions, drawing heavily on Sarno
and Taylor (2001) and Frenkel et al. (2001).
We dene an exchange market intervention as a sale or a purchase of
foreign currencies by the monetary authorities with the aim of chang-
ing the exchange rate of their own currency vis--vis one or more
foreign currencies. Coordinated (or concerted) ofcial intervention
Table 3.7
Estimates of the equilibrium value of the euro
Reference Equilibrium
Study period Methodology rate (against $)
Wren-Lewis and 2000 Equilibrium FEER 1.191.45
Driver (1998) model
Alberola et al. (1999) End 1998 Internal/external 1.26
balance
Borowski and First half of 1999 model Equilibrium 1.231.31
Couharde (2000) FEER model
Van Aarle et al. (2000) 2000:II Monetary model 1.07
Gern et al. (2000) 2000:I BEER, uncovered 1.03
interest parity
Clostermann and Winter 1999 Real long-term yield Short run 1.20
Schnatz (2000) 2000 spread, oil price, Medium run
government spending, 1.13
relative price of
traded to nontraded
goods
Teletche (2000) June 2000 Relative productivity, 1.09
government spending,
real long-term yield
spread, M1, industrial
production
Hansen and Roeger 1999:III PEER Undervation:
(2000) 15% against
trading
partners
Lorenzen and 19992000 BEER Long run 1.28;
Thygessen (2000) medium run
1.19; Short run
1.09
IMF (2000b) Summer 2000 Saving-investment Undervaluation
30%
Schulmeister (2000) Mid 2000 PPP for tradables 0.87
Stein (2001) 2001:I NATREX 1.17
Duval (2001) 2000:III Natrex and Balassa 1.15
Samuelson
Alberola et al. (2002) End 1999 Internalexternal Undervaluation
balance model 12.4% against
trading
partners
Alquist and Chinn June 2000 Monetary model Medium run
(2001) (M1, GDP, interest 1.171.24
differentials) and
relative productivity
growth
66 Chapter 3
Table 3.7
(continued)
Reference Equilibrium
Study period Methodology rate (against $)
Koen et al. (2001) Second half 2000 BEER Undervaluation
9%
Maeso-Fernandez 2000:IV BEER/PEER Undervaluation
et al. (2001) of 3 to 20%
Detken et al. (2002) End 2000 Four different models, Undervaluation
including structural differs widely,
VAR and NATREX ranging from 5
to 27%
Source: Koen et al. (2001), European Economic Advisory Group at CESifo (2002), ECB
(2002) and own update.
Note: The BEER (behavioral equilibrium exchange rate) approach is not based on a spe-
cic structural model but encompasses several variables. Often those fundamentals have
medium-run effects but wash out in the longer run. The PEER (permanent equilibrium
exchange rate) methodology builds on the BEER methodology and decomposes the vari-
ables into permanent and transitory components. The FEER (fundamental equilibrium
exchange rate) methodology places more structure on the computation of the equilib-
rium exchange rate. The NATREX (natural real exchange rate) approach is founded on
a more rigorous modeling of the stock-ow interaction in a macroeconomic growth
model. A distinction is made between a medium-term equilibrium, where external and
internal balance prevails (equivalent to the FEER approach), and the long-run equilib-
rium, where net foreign debt is constant and the capital stock is at its steady state level.
Internal balance is obtained when a country has full employment and low ination, while
external balance corresponds to a sustainable current account position.
4 Impact of News on the EuroDollar Exchange Rate
A number of recent papers have examined the impact of so-called news
on the eurodollar exchange rate. These studies have the assumption that
foreign exchange markets are efcient in common, meaning that all infor-
mation relevant for the pricing is instantaneously reected in the
exchange rate. The exchange rate reacts to new information that may be
relevant for exchange rate pricing, just as news on economic develop-
ments or on monetary policy.
Galati and Ho (2001) investigate how daily news reports on macro-
economic conditions in the United States and in the euro area (e.g., unem-
ployment conditions, industrial production reports, consumer prices)
affect the eurodollar exchange rate. They nd that during the rst two
years of EMU, bad macroeconomic news tended to depreciate the euro
but good macroeconomic news did not similarly always lead to an
appreciation of the euro. Often the market seemed to ignore good news
from the euro area, in line with the views of De Grauwe (2000). De
Grauwe (2000) explained the weakness of the euro since 1999 in terms of
how markets form views about the factors driving exchange rates. First,
De Grauwe identied some fundamental variables that determine the
eurodollar rate. Unexpected changes in these variables, namely the
news component, were assumed to inuence the exchange rate. De
Grauwe found that in most cases the news on the US fundamentals was
less favorable than the news on the European fundamentals. De Grauwe
argued that because of the great uncertainty about equilibrium levels of
exchange rates, short-run movements tend to be driven by technical and
chartist analysis. Sustained movements in one direction or another then
lead to a search for fundamentals that explain these developments
(framing). When the exchange rate changes, a search starts for funda-
mentals that can explain the observed change. This way a self-enforcing
process can evolve: a declining euro is seen as evidence that there are
problems in the economy of the euro area. These problems then reinforce
the downward movement of the euro. So the causality is reversed: it is
not the news about fundamentals that drive the exchange rate but the
exchange rate that determines the way the fundamentals are perceived.
De Grauwe saw the results of Corsetti and Pesenti (1999) and Corsetti
(2000) as additional proof for his theory. Since there was great optimism
about the future growth of the US economy, nancial market analysts
focused solely on the variable that supported these beliefs: the growth
rate. Little attention was paid to other fundamentals. Once the direction
of change becomes different, the search for new fundamentals that can
explain this development begins.
Fatum and Hutchison (2002) examined the impact of certain news
paper reports. The nancial press have reported numerous rumors of
intervention, ofcial statements expressing views regarding the value of
the euro as well as statements on the usefulness of intervention. These
authors investigated whether statements and rumors of this nature
reported in the press are systematically related to the eurodollar
exchange rate changes. The reports were separated into four categories:
Rumors and speculation of euro support intervention
Statements by ofcials in support of the euro
Statements by ofcials not supportive of the euro
Firm reports of intervention

In their model for the eurodollar exchange rate, statements by ECB
ofcials in support of the euro and reports of ECB intervention in support
of the euro are not statistically signicant. However, ofcial statements
denying ECB intervention have worked to depreciate the value of the
euro. This effect is persistent over a week at least. Rumors and specula-
tion of intervention in support of the euro are associated with euro appre-
ciation, but the effect is not persistent.
68 Chapter 3
Jansen and De Haan (2003) also examined the impact of statements of
ECB and other European central banks ofcials, using reports in
Bloomberg. In contrast to Fatum and Hutchison (2002), they took a much
broader array of statements into account. Over the period January 1,
1999, to May 17, 2002, they identied 936 news reports on monetary
policy or the euro. They concluded that most of these statements had no
effect on the exchange rate. The only positive effect stems from state-
ments suggesting that the ECB may intervene at the foreign exchange
market. Jansen and De Haan further examined whether there are sys-
tematic differences between the effects of statements of different central
bankers. Table 3.8 is reproduced from this study. It follows that there is
a systematic difference in terms of the impact: statements of Bundesbank
ofcials had some short-run impact in contrast to statements from other
central bankers, including ECB President Duisenberg.
Table 3.8
Effect of statements of central bankers on the eurodollar exchange rate
Variables Coefcient p-Value
EB+ (1) -1.84 0.75
EB+ (0) 5.33 0.34
EB+ (-1) -3.79 0.54
EB+ (-2) -2.14 0.73
EB0 (1) -9.89 0.20
EB0 (0) -1.88 0.82
EB0 (-1) 3.16 0.70
EB0 (-2) -8.17 0.27
EB- (1)*** -26.51 0.01
EB- (0) 3.20 0.77
EB- (-1) 13.29 0.23
EB- (-2) -8.85 0.45
NCB+ (1) -1.10 0.84
NCB+ (0) -3.16 0.56
NCB+ (-1) 2.85 0.60
NCB+ (-2) -7.77 0.15
NCB0 (1) 1.09 0.89
NCB0 (0) -7.68 0.28
NCB0 (-1) 12.05 0.12
NCB0 (-2) -2.95 0.72
NCB- (1) -4.47 0.59
NCB- (0) -9.83 0.22
NCB- (-1) 7.25 0.41
Table 3.8
(continued)
Variables Coefcient p-Value
NCB- (-2) -5.19 0.48
BuBa+ (1) -9.86 0.37
BuBa+ (0) 9.79 0.27
BuBa+ (-1)** -23.03 0.04
BuBa+ (-2)*** -30.18 0.01
BuBa0 (1)** -20.73 0.05
BuBa0 (0) 6.19 0.56
BuBa0 (-1)* -18.16 0.08
BuBa0 (-2) 9.06 0.37
BuBa- (1) -29.37 0.16
BuB- (0)** 31.23 0.03
BuBa- (-1) 17.79 0.17
BuBa- (-2) 18.42 0.24
R
2
0.06
Adjusted R
2
0.00
DW 2.00
Source: Jansen and De Haan (2003).
Note: The estimated model is
Here R
t
represents the change in the natural logarithm of the exchange rate, D
k
repre-
sents dummies for the ECB statements (EB denotes Executive Board, NCB is national
central banker, and BuBa is Bundesbank). The second equation also has dummies for the
weekdays (D
m
. . . D
th
) and the change in the interest differential between the United
States and the euro zone (i
US
- i
EU
) as control variables. The error term has a zero mean
and an conditional variance h
t
. A GARCH(1,1) specication is used. The weekday
dummies also enter the variance equation. Only the results for the statement dummies
are shown. Aplus means a positive statement, a zero indicates a neutral statement, while
a minus indicates a negative statement. The statement dummies enter the equation with
one lead, the current value and two lags. All coefcients are multiplied with a factor
10,000.
*/**/*** denotes signicance at the 10/5/1% level.
R R D i i
D D D D h
h h D D
t i
i
t i ki
i
k t i
k
K
id t
US
t
EU
m m tu tu w w th th t t t
t t t m m tu tu w
= + + + - ( )
+ + + + + ( )
= + + + + +
=
-
=-
-
=
- -

b b b b
b b b b e e
d d e d d d d
0
1
5
1
2
1
0 1 1
2
2 1
0
,
, ~ , ,
D
DD D
w th th
+d .
70 Chapter 3
occurs when two or more central banks intervene simultaneously in
the market in support of the currency, according to an explicit or
implicit agreement.
The purchase (sale) of foreign currency by the central bank leads to
an increase (decrease) in the net foreign assets at the balance sheet of
the monetary authorities, and an equivalent increase (decrease) in the
monetary base (M). So interventions at the foreign exchange market
have basically the same effect on M as an open market operation. There
is no debate that this will inuence exchange rates. The debate is on
the question of whether sterilized interventions will have an effect. If
intervention is sterilized, the effects of the intervention on M are offset
one for one by the central bank. Normally this is done through sales or
purchases of domestic-currency bills or bonds, in other words, through
an offsetting open market operation.
By far the larger part of exchange market intervention is carried out
in the spot market. The reason for this seems to be that an intervention
operation derives a great deal of its effect from the announcement of
the operation itself. Highly visible spot market operations conrm the
announcement.
Sterilized purchases and sales of foreign exchange by a central bank
can, in theory, have an impact on the exchange rate. Sarno and Taylor
(2001) distinguish the portfolio balance channel and the signaling
channel. Central in the portfolio balance channel is that after the inter-
vention the composition of the agents portfolios has changed, since the
central banks will have bought or sold domestic assets in their steril-
ization operations. When agents try to rebalance their portfolios by
buying or selling foreign assets, the spot exchange rate will shift. A
crucial assumption in the portfolio balance channel is that agents
regard domestic and foreign assets as imperfect substitutes, meaning
that there is a risk premium between foreign and domestic assets. If
they were perfect substitutes, agents do not have any incentive to rebal-
ance their portfolio.
Even if domestic and foreign assets are perfect substitutes, sterilized
intervention may have impact on exchange rates through the signaling
or expectations channel. If the foreign exchange markets are efcient, all
information relevant for the pricing is instantaneously reected in the
exchange rate. So why can an intervention effect exchange rates? The
basic idea of this channel is that the central bank may have an infor-
mational advantage over private agents. The central bank may have
access to information that is not (or only after a certain time lag) avail-
able to market participants. It is assumed that the monetary authori-
ties have superior information to other market participants and that
they are willing to reveal this information through their actions in the
foreign exchange market. This information may refer to fundamentals
(including future policy). So agents may process the new information
and adjust their expectations regarding the future evolution of funda-
mentals. For instance, they may view the intervention as a signal about
the future stance of monetary policy.
Another channel through which sterilized central bank interventions
may affect exchange rate has been discussed in the strand of the liter-
ature concerned with the noise trader model of exchange rate determination
(Frenkel et al. 2001). Noise traders are nancial market participants
whose demand for a nancial security is not inuenced by economic
fundamentals alone. Instead, they employ techniques provided by, for
example, technical chart analysis to extract buy and sell signals from
historical exchange rate trajectories. In noise trader models of exchange
rate determination it is assumed that at least in the short and medium
run, the group of noise traders inuences the dynamics of the exchange
rate so that the price of this asset can depart from its fundamental
value. If the central bank succeeds in affecting the exchange rate and
noise traders respond to these changes, the price impact of noise
traders orders may then account for persistent exchange rate effects of
sterilized foreign exchange market interventions.
21
In general, empirical research on the effectiveness of exchange market
interventions was for a long time hampered by a lack of sufciently
detailed data. For example, the German and Swiss central banks
swapped foreign exchange with commercial banks. As these swaps are
included in the changes in ofcial reserves, the latter does not accu-
rately reect ofcial interventions. Furthermore, estimating the portfo-
lio balance channel requires proxies for the risk premium between
domestic and foreign assets.
According to Sarno and Taylor (2001), the portfolio balance channel
has not attracted a large empirical literature relative to other models of
exchange rate. Two types of test have been conducted. The rst type is
based on estimating a reduced form solution of the portfolio balance
model (PBM) in order to measure its explanatory power. The second
type focuses on solving the PBM for the risk premium and testing for
perfect substitutability of bonds, where the risk premium is measured
by deviations from uncovered interest parity. The empirical studies on
testing the PBM published in the late 1970s and in the 1980s suggested
that sterilized intervention is effective at most in the very short term.
Furthermore the effects of interventions through the portfolio balance
72 Chapter 3
channel are very small in size (Sarno and Taylor 2001). Data on
ofcial exchange rate intervention and survey data on exchange rate
expectations became available for utilization during the late 1980s.
Especially the work by Dominguez and Dominguez and Frankel has
led to the conclusion that interventions may have some impact through
the portfolio balance channel and the signaling channel. Below we
summarize this literature, while sidebar 5 discusses more recent evi-
dence based on the so-called event study approach.
22
Dominguez and Frankel (1993b) estimate a portfolio-balance
equation using survey data on US dollarGerman mark and US
dollarSwiss franc exchange rate expectations in the mid-1980s to con-
struct measures of the risk premium as the deviation from uncovered
interest rate parity. They nd that intervention variables have statisti-
cally signicant explanatory power in a regression for the risk
premium. There is strong support in favor of a signicant portfolio
balance effect.
5 Are Interventions Effective After All? Some Recent
Evidence
Exchange rates are highly volatile on a daily basis and interventions
come generally in sporadic clusters. Traditional time series modeling
may therefore not be the most appropriate tool for analysis. Fatum and
Hutchison (2003) therefore apply the event study approach used in the
nance literature to data on Bundesbank and Fed interventions over the
period September 1985 (Plaza Agreement) to December 1995. The start-
ing point for an event study is to dene the event and to identify the
period over which the security price is examined. Interventions often
comprise more than one day. Therefore Fatum and Hutchison (2003)
dene the event as a period of days with ofcial intervention in one direc-
tion conducted by either the Bundesbank, the Fed, or both, possibly with
a number of days (with a maximum of 2, 5, 10, or 15 days) with no inter-
vention. Fatum and Hutchison employ three criteria to judge whether an
intervention has been successful. First, is the direction of change the same
as the direction in which the central bank was intervening (direction
criterion)? Second, is the intervention associated with a smoothing
exchange rate movement (smoothing criterion)? Finally, has the inter-
vention led to a change of the exchange rate movement (reversal crite-
rion)? The null hypothesis of no link between the intervention event and
the subsequent short run exchange rate movements is rejected for all the
criteria for success. The authors conclude therefore that interventions
appear to inuence exchange rates in the short run, although the method-
ology does not allow to identify the channel though which these inter-
ventions have an effect.
Frenkel et al. (2001) also apply the event study approach, using ten-
minute exchange rate returns for the dollareuro spot exchange rate on
the days on which the ECB intervened in the foreign exchange markets.
These authors nd that the interventions of the ECB resulted in an imme-
diate and statistically signicant appreciation of the euro vis--vis the US
dollar. This effect persisted to a certain extent on the intervention day.
However, in all cases of foreign exchange market intervention, the euro
depreciated on the day following the intervention suggesting that the
effect of the interventions of the ECB was not persistent over a longer
horizon.
Fatum and Hutchison (2002) apply the event study methodology to
the rm newspaper reports of euro intervention that they identied (see
sidebar 4). Two separate events emerge: a one-day event on September
22, 2000, and a three-day event spanning from November 3 through 9,
2000. The authors examine windows of 2, 5, 10, and 15 days. The rst
event appears successful according to all three criteria outlined above
when the analysis is based on the shorter window lengths. However,
when the analysis is based on the longer window lengths, the Septem-
ber 22 event appears unsuccessful with respect to the direction and
reversal criteria. The November 3 through 9 events appears successful
when the analysis is based on the shorter window lengths and the
window of 15 days. When the analysis is based on the 10-day window,
the event appears unsuccessful. Fatum and Hutchison (2002) conclude
that their evidence provides some support for the short-run efcacy of
ECB intervention operations, but the effects are not long lasting. They
also nd that negative statements by ECB ofcials questioning the ef-
cacy of intervention, denying past intervention, and ruling out future
intervention have systematically depreciated the euro and the effect
appears persistent.
Finally, Payne and Vitale (2003) study the effects of sterilized inter-
vention operations of the Swiss National Bank (SNB). They use a trans-
action-based data set of the activities of the SNB between 1986 and 1995
and combine this information with exchange rate quotes documented
in news-wire reports. Payne and Vitale use the event study approach
and quantify the effects of single intervention operations on the US
dollarSwiss franc rate at a 15 minutes sampling frequency. They nd
that even after accounting for the interventions of other central banks,
the effects of the SNB interventions on the exchange rate are strong and
persistent. The effectiveness of coordinated interventions is higher, while
the impact of interventions is larger when the interventions follow the
current trend rather than opposing it.
74 Chapter 3
Dominguez (1990) investigates whether ex post one-day, thirty-day,
and ninety-day excess returns in the US dollarGerman mark and US
dollaryen market are related to unilateral and coordinated interven-
tion by the Bundesbank, the Federal Reserve System, and the Bank of
Japan. She nds mixed results for the various subperiods distin-
guished. Also coordinated intervention had a signicantly different
and longer term inuence on market expectations than did unilateral
intervention over the three-year period examined (p. 158).
Dominguez and Frankel (1993a) estimate a two-equation system
where one of the equations denes the expectations formation mecha-
nism and the other equation is an inverted portfolio balance equation
that allows for mean-variance optimization. The authors report strong
statistical evidence supportive of the effectiveness of sterilized inter-
vention through both the portfolio balance channel and the signaling
channel. They conclude that intervention can be effective, especially
if it is publicly announced and concerted. It may be that sterilized inter-
vention can only have effects in the short term. But if short-term
effects include the bursting of a nine-month bubble earlier than it
would otherwise have burst, then such an effect may be all that is
needed (p. 140).
Dominguez (2003) investigates the inuence of Fed intervention
operations on both dollarDmark and dollaryen intra-day returns and
volatility. She nds evidence supporting the hypothesis that central
bank interventions inuence intra-daily foreign exchange returns and
volatility. In order to get the largest effects the central bank should time
intervene when the trading volume is high. Furthermore, the inter-
ventions should occur in the aftermath of the release of other macro-
economic news and when other central banks are also intervening in
the market (coordinated interventions).
3.7 Asset Price Ination
Several reasons exist why central banks may worry about asset price
ination. First, assets are claims on future services, so asset prices are
a proxy for the prices of future consumption. An effective measure
of ination should therefore include asset prices.
23
As Goodhart (2001,
p. 3) puts it:
My dictionary denes ination as a fall in the value of money, not as a rise in
the consumer price index. If I spend my money now on obtaining a claim on
future housing services by buying a house, or on future dividends by buying
an equity, and the price of that claim on housing or on dividends goes up, why
is that not just as much ination as when the price of current goods and ser-
vices rises?
However, Gilchrist and Leahy (2002) point out that asset prices change
for many reasons and not all of them are related to the cost of future
consumption. Asset prices may rise when expected prots rise while
interest rates may remain unchanged. This implies that changes in asset
prices reect changes in the quantity of future consumption rather than
changes in the price of future consumption (Camba-Mendez 2003).
Second, if rising asset prices spill over into excess demand, asset
prices can be leading indicators of CPI ination. Consumption will rise
through an increase in wealth and rising share prices reduce the cost
of capital, so rms invest more. Third, asset price bubbles will distort
price signals and cause a misallocation of resources. Firms will, for
example, overinvest in risky projects if the cost of capital is articially
low. Finally, a bursting bubble may cause severe economic and nan-
cial harm. The earlier the bubble is pricked, the less pain it may cause.
The rst point is an argument against the denition of ination as
currently used by the ECB, and many other central banks. The other
arguments are basically a plea to take asset prices into account in the
reaction function for the monetary authorities, either directly (as an
objective) or indirectly (as an indicator for other objectives, e.g., ina-
tion). As explained in section 2.3, the ECB uses asset price develop-
ments in its broadly based assessment of the risks for price stability.
However, the ECB does not explicitly target asset prices.
While identifying nancial imbalances ex ante can be difcult, Borio
and Lowe (2002) suggest that it is not impossible. Sustained rapid
credit growth combined with large increases in asset prices appears to
increase the probability of an episode of nancial instability. Low and
stable ination promotes nancial stability and it also increases the
likelihood that excess demand pressures show up rst in credit aggre-
gates and asset prices rather than in goods and services prices. Amon-
etary response to credit and asset market developments may be useful
to preserve both monetary and nancial stability. Likewise Cecchetti
et al. (2000) argue that if the authorities target asset prices explicitly, it
is possible to stop bubbles from getting too far out of hand, thereby
avoiding boombust cycles. The main argument against this view is
that it is impossible to distinguish ex ante between fundamental causes
that raise asset prices and the existence of a bubble in asset prices.
Central banks are able to make better judgments only if they have
76 Chapter 3
superior information in comparison to the private sector. As Mishkin
(2001, pp. 1516) puts it:
Without an informational advantage, the central bank is as likely to mis-predict
the presence of a bubble as the private market and thus will frequently be mis-
taken, thus frequently pursuing the wrong monetary policy.
Furthermore an objective for asset prices assumes that central banks
are able to inuence asset prices. However, most empirical evidence
suggests that the link between stock prices and monetary policy is
weak at best. Most uctuations in stock prices occur for reasons unre-
lated to monetary policy. Therefore Bernanke and Gertler (2000) argue
that a central bank dedicated to price stability should pay no attention
to asset prices per se, except insofar as they are signals of changes in
expected ination. According to these authors it is problematic to
stabilize asset prices because it is nearly impossible to know for sure
whether a given change in asset prices results from fundamental
factors, nonfundamental factors, or both.
What about real estate prices? Boombust episodes seem to be more
frequent in real property prices than in stock prices (Bordo and Jeanne
2002). In most countries changes in house prices seem to have a bigger
impact on consumer spending than do equity prices. Investing in prop-
erty may lead to a capital gain and also yield rental income. Buying a
house is particularly attractive because of the tax treatment of housing.
A housing bubble is associated with more debt than a stock market
bubble. This makes a housing bubble more dangerous. When the house
prices fall sharply, this can harm the economy more than a similar fall
in share prices.
Still Vickers (1999) argues that house prices should not be an inde-
pendent concern of monetary policy. The prices matter to the extent
that they contain information about ination prospects. The relation-
ship between house prices and ination are complex and imperfectly
understood, according to Vickers (1999). He argues that the effects of
higher house prices on consumer spending are far from unambiguous.
The foregoing analysis suggests that a central bank should not apply
an objective for asset and house prices. But what about a broader def-
inition of price stability (see sidebar 6)? The inclusion of equity prices
in the denition of price stability has actually some other major draw-
backs of an empirical nature (Camba-Mendez 2003). First, the large
volatility and/or potential for bubbles in equity prices can add too
much noise to a measure of ination, thereby making it more difcult
to extract the true signal from price developments. Second, it is very
risky for a central bank to try to smooth large changes in asset prices.
If, for example, a central bank tries to correct for sharp falls in asset
prices, this can ultimately lead to larger asset price bubbles as investors
may count on the central bank to come to their rescue. Third, the empir-
ical evidence supports a link between real estate prices and output, but
this link is much weaker for equity prices (see Cecchetti et al. 2000;
Goodhart and Hofmann 2000). Goodhart (2001) was led to suggest
that a measure of ination should accord some weight to housing
prices but not to equity prices.
6 Implications of a Broader Denition of Price Stability
Arnold et al. (2003) examine a broader denition of price stability for
ECBs policies by way of the euromon model. In their denition of price
stability, they use various weights for asset prices, following Bryan et al.
(2001), to observe the effects of the inclusion of stock prices and housing
prices. Their counterfactual simulation starts in 1994 and ends in 2001
for the case where the objective of the ECB (ination not exceeding 2
percent) remains in place. The standard reaction function assumed in the
euromon model is based on the Taylor rule. The broad ination rate p(t)
is dened as:
where p
cp
is the consumer price ination, p
h
is the price increase of
houses, and p
eq
is the rate of increase of equity prices. The weights for
housing prices are 10 and 20 percent and for equity prices the weights
are 0.5, 2, and 4 percent. Table 3.9 shows the simulation results. The table
shows the mean (M) and the standard deviation (SD) of the annual rate
of growth of real GDP (y), consumer price ination, the policy rate (RS)
housing price ination, and equity price ination for the period 1994 to
2001. Both the actual (realized) and the simulated outcomes according to
euromon are shown for a broad denition of price stability by the ECB.
Columns 2 and 3 of the table show that the inclusion of housing prices
implies a higher interest rate. Consequently output growth is lower if the
ECB employs a broader denition of price stability, whereas CPI ina-
tion is higher. If equity prices are included in the denition of price sta-
bility, interest rates are, on average, only slightly higher, and output
growth slightly lower (columns 47 of table 3.9). If both housing and
equity prices are included (column 8), interest rates slightly rise and
output falls compared to the base scenario. Nevertheless, the analysis
suggests that, all in all, the effects of a broader denition of price stabil-
ity would be small for the period under consideration.
p j p j p j p j j j t t t t
cp cp h h eq eq cp h eq
( )
=
( )
+
( )
+
( )
+ + = with 1,
78 Chapter 3
3.8 Interest Stepping versus Smoothing
Should interest rates be changed gradually or not? So far the ECB has
changed interest rates either by 50 basis points (7 times) or 25 basis
points (8 times). Arguments have been put forward for both bigger
(interest rate stepping) and smaller steps (interest rate smoothing).
Interest rate stepping can be dened as the tendency of interest rates
to remain xed for a while in an environment that is being continually
hit by shocks to the determinants of future ination and growth. As
a result the interest rate is shifted in discrete jumps while the deter-
minants evolve smoothly (i.e., continuously) over time. This practice
should be clearly distinguished from the practice of interest rate smooth-
ing, which denotes a situation where a required interest rate change is
implemented by a series of small steps in the same direction rather than
by a single step at once.
There are several rationales for not changing the interest rate continu-
ously. According to Eijfnger and Huizinga (1999), central banks can
maintain a lower rate of ination by a commitment not to change the
interest rate in every period. Since the costs of a sudden ination are
permanentand will induce an increase in inationary expectations
while the benets are temporary, such a commitment will induce the
Table 3.9
Actual and simulated macroeconomic developments in EMU, 19942001
Realized Counterfactual with broad denition of ination
j
cp = 0.90
j
cp = 0.80
j
cp = 0.995
j
cp = 0.98
j
cp = 0.96
j
cp = 0.96
j
cp = 0.88
j
h = 0.10
j
h = 0.20
j
h = 0.00
j
h = 0.00
j
h = 0.00
j
h = 0.00
j
h = 0.10
j
eq = 0.00
j
eq = 0.00
j
eq = 0.005
j
eq = 0.02
j
eq = 0.04
j
eq = 0.04
j
eq = 0.02
(1) (2) (3) (4) (5) (6) (7) (8)
M y 2.22 2.14 2.06 2.20 2.12 2.02 2.01 2.06
SD y 0.84 0.81 0.81 0.81 0.75 0.69 0.79 0.73
M p
cp
2.23 2.32 2.41 2.21 2.17 2.12 2.18 2.26
SD p
cp
0.74 0.68 0.63 0.74 0.74 0.76 0.74 0.68
M RS 4.68 4.84 4.98 4.69 4.75 4.88 5.02 4.89
SD RS 1.24 0.93 0.74 1.24 1.32 1.47 1.10 1.02
M p
h
3.07 3.09 3.10 3.01 2.84 2.62 2.75 2.88
SD p
h
2.05 1.99 1.95 2.01 1.91 1.77 1.77 1.89
M p
eq
11.84 10.92 10.12 12.26 13.32 14.24 11.63 12.25
SD p
eq
21.05 20.30 19.86 19.91 17.00 14.22 19.07 16.72
Source: Arnold et al. (2003).
central bank to be more aware of the costs of an expansionary policy.
The result will be an increase in the central banks credibility for ght-
ing ination. Hence especially for the ECB, which does not have a
historical record for ghting ination, a commitment to interest rate
stepping is likely to be benecial.
Another good reason for stepping is provided by Eijfnger et al.
(1999) and is based on the fact that interest rate changes are costly to
the central bank. The cost is loss of reputation in the nancial markets.
Too many stepsand especially too many reversalslead to a per-
ception of a central banks incompetence. Too many steps can even
impede the signaling value of a change in monetary policy, especially
in an environment where there is a lot of uncertainty. Because mone-
tary policy takes place in a dynamic framework, the central bank has
to take into account that it has the option to wait and see whether the
economy will move back toward the ination target of its own accord.
In particular, the higher the uncertainty, the more the central bank
should not attempt to change the interest rate.
A third reason, due to Goodfriend (1991), argues that by imple-
menting a policy of interest rate stepping central banks can obtain more
leverage over longer term interest rates. This is benecial because these
rates are generally agreed to affect aggregate demand.
There are also some good arguments for smoothing (Goodhart 1996).
The primary one concerns the presence of multiplier uncertainty
(Brainard 1967). If the central bank is uncertain about the impact of a
change in the interest rate on output and ination, and if it cares about
the variances of ination and output around, respectively, the ination
target and the natural rate, there will be a tendency for caution. The
reason is that large changes in the monetary policy stance (with the aim
setting the conditional mean rate of ination equal to the target) will
increase the expected variability of output and ination.
Arelated argument is that if central banks implement small changes
in the presence of uncertainty, then they can assess the effect of each
change, and subsequently whether or not a further change is needed.
However, this can be dangerous because there are long and variable
lags in monetary policy. So the central bank will risk falling behind the
curve (i.e., doing too little too late).
Empirical evidence by Eijfnger and Huizinga (1999) suggests that
a relative activist monetary policy does not result in higher output
growth but rather in more costs because of a higher average and
80 Chapter 3
variability of ination in the long run. The experience with the ECBs
interest rate policy balancing bigger steps (50 basis points) and smaller
changes (25 basis points) indicates that the ECB is still undecided on
whether to go with interest rate stepping or smoothing.
3.9 Conclusions
What do we make out of all this? In our view the ECB has been quite
successful in its monetary policy so far. Ination in the euro area has
remained low, although it has exceeded 2 percent almost continuously
since mid-2000, which is for most of the ECBs history. Still this has not
led to increases in expected ination. Furthermore the ECB cannot rea-
sonably be said to have been overly aggressive in pursuing its primary
objective to the detriment of other considerations. So critics who argue
in favor of an ination objective above 2 percent should be quite
content with actual ECB policies. In addition most of the policy deci-
sions have been in line with market expectations, although there were
some surprises and sometimes the market expected a different timing
of the steps taken by the ECB.
Despite this favorable assessment, we believe that the ECB can
improve the transparency of its monetary policy strategy. First, it
should drop altogether the rst pillar and concentrate, exclusively, on
a more explicit ination targeting strategy. Second, the ECB should
provide a midpoint ination target that includes a symmetric band or
range around it. On the basis of the various arguments put forward in
this chapter, we favor a midpoint ination target of 2 percent with a
range of 1.5 to 2.5 percent.
As to the role of the rst pillar, most of the academic literature favors
less emphasis on the role of money in the monetary strategy of the
ECB and a (gradual) move toward ination targeting. The main
problem with the role of money in the strategy of the ECB is that it is
widely misunderstood by many observers and therefore creates the
impression that the ECB lacks transparency (see also chapter 4).
We therefore conclude that the ECB should abandon the monetary
analysis as a dominant navigation system for its monetary policy. The
abolishment of the rst pillar would avoid confusion and increase
transparency. However, it is unrealistic to think that focusing on the
present second pillar will do away entirely with the problem. Just
keeping the second pillar in place will lead to similar problems, as
it contains many indicators that are unlikely to point in the same
direction at the same time. Therefore an ination-targeting strategy is
to be preferred.
As to the ination objective, in our view the arguments put forward
for raising the ination objective substantially are not compelling. Our
reading of the literature leads us to the conclusion that the conse-
quences of the zero bound are negligible for target ination rates as
low as 2 percent. Likewise the upward measurement bias in ination
in the euro area seems to be less of a problem than in the United States.
Also the risk of deation in an individual country in the euro area
seems to be small. The evidence on the Balassa-Samuelson effect is so
mixed that we do not consider this to be a convincing argument for a
higher ECB ination objective (see also chapter 5).
The ECB cannot target the external and the internal value of the euro
at the same time. Because the ECBs mandate is for price stability, the
internal value of the euro takes priority. However, this does not imply
that the eurodollar exchange rate is not important as the euro-dollar
exchange rate affects ination. The ECB has occasionally also expressed
concern that the exchange rate may not be in line with fundamentals.
Whether interventions are needed to bring the exchange rate in line
with these fundamentals is doubtful. Although there is some evidence
of short-run effectiveness of sterilized foreign exchange intervention,
there is up until now too little evidence of its persistence over a longer
horizon.
Some academics have argued that central banks should either
broaden their denition of ination by including asset prices or directly
target asset prices. The ECB rightly takes the information that asset
prices may contain with respect to future ination into account under
its second pillar. To take asset prices into account in dening ination
is a step we would not endorse, since asset prices change for many
reasons and not all of them are related to the cost of future consump-
tion. As to the wealth effects and the pass-through of asset and prop-
erty ination to goods and services ination, there is at present no
conclusive empirical evidence of their relevance. Furthermore the
inclusion of asset prices into the denition of price stability would add
too much noise to a measure of ination because of the large volatility
and/or potential bubbles in equity prices. This makes it more difcult
to extract the true signal from price developments.
4.1 Introduction
For a long time central banks have been associated with secrecy.
Recently, however, various central banks, including the Bank of
England and the Reserve Bank of New Zealand, have embraced open-
ness. A comprehensive survey of 94 central banks by Fry et al. (2000)
reveals that 74 percent of the respondents consider transparency a vital
or important component of their monetary policy framework.
There exist differences in the literature as to the denition of trans-
parency. Basically two kind of denitions can be distinguished. Some-
times transparency refers to the activities of the central bank in
providing information. In other cases transparency relates to the
publics understanding of monetary policy.
When a central bank is open about its policies, the general public can
get a good understanding of the decisions taken by the monetary
authorities and the reasoning behind them. In line with this Winkler
(2000) denes transparency as the degree of genuine understanding of
the monetary policy process and policy decisions by the public. Pro-
moting public understanding involves monetary authorities being
active in developing and conveying information, using the various
means available to disclose information, and tailoring the message
according to the needs of particular audiences. We will use the term
disclosure whenever we refer to the activities of the central bank to
enhance the understanding of the public of its policies (see also Siklos
2002).
1
The concept of transparency as dened by Winkler (2000) and the
activities of the central bank to promote this understanding (disclosure)
are related. In principle, it is possible that the public does have a good
understanding of the policies of the central bank (or claims that it has),
4
Transparency,
Accountability, and
Credibility of the ECB
84 Chapter 4
although the central bank hardly provides information on the decisions
taken and the reasoning behind them. Alternatively, the central bank
may be very active in providing information, while the public feels that
it does not fully understand what the central bank does. Whether the
activities of the central bank lead to a better understanding depends
on many factors, some of which are discussed in the present chapter.
One of the crucial factors, of course, is the quality of the information
provided. No matter how often a central bank publishes information,
if the receivers of it feel that this information is hard to understand, the
central bank may not be transparent.
In this chapter we rst discuss issues of disclosure and transparency
of central banks. In the next section we start by reviewing the litera-
ture on disclosure and transparency distinguishing between various
types of disclosure. In section 4.3 we discuss recently developed indi-
cators of central bank disclosure. We also discuss in this section the
transparency of the ECB as perceived by nancial markets.
According to Issing (2001a), transparency of monetary policy making
is thought to bring various benets. First, democratic accountability of
central banks requires disclosure. Whatever other arrangements con-
cerning democratic accountability may exist, their scope is limited
without proper information concerning the behavior of central banks
as this is crucial for the evaluation of its performance.
2
In section 4.4
we consider the accountability of the ECB.
Second, transparency of monetary policy making may enhance the
effectiveness and credibility of monetary policy. By providing the
public with adequate information about its activities, the central bank
can establish a mechanism for strengthening its credibility by match-
ing its actions to its public statements (IMF 2000a).
Although economists often base their models on the notion of cred-
ibility, little is actually known about what that means. For instance,
how does a central bank become credible? Should a central bank be
independent to be credible? Blinder (2000) held a survey among central
bankers on the credibility of central banks (section 4.5). Blinders
respondents considered credibility important to keep ination low.
The best way for a central bank to earn credibility is to have a history
of doing what it says it will do. We have done a similar survey among
professional economists from a broad sample of countries (section 4.6).
Because we ask the same questions as Blinder did, we are able to
examine whether private sector economists share the views of central
bankers on these matters. In this section we also examine the credibil-
ity of the ECB. The nal section offers some concluding comments.
4.2 Transparency and Disclosure: Theory and Evidence
4.2.1 Various Facets of Disclosure
To understand the role that transparency plays in monetary policy, it
is important to examine the interrelationship between the disclosure of
a central bank and transparency of monetary policy. Figure 4.1 is a styl-
ized account of how information provided by the central bank (disclo-
sure) will affect the publics understanding of the monetary policy
process (transparency). The top panel depicts the central banks inter-
nal activity of information processing, analysis, and decision making.
On the basis of the monetary policy strategy, the central bank reaches
a decision about monetary policy that is communicated to the outside
world. In this process the monetary policy strategy is, again, crucial as
the central bank will use it in explaining the reasons for reaching a
certain decision. The public receive most of the information through
print and broadcast media.
3
The effect of monetary policy on ination
and output growth (outcome) is determined not only by monetary
policy decisions but also by the expectations and the behavior of the
Transparency, Accountability, and Credibility of the ECB 85
Objectives
Input (raw data) Central bank strategy Output (decisions)
Communication about strategy (disclosure)

(activities, contents)
Outcomes
Reporting about strategy
by intermediaries
Publics understanding (transparency) Behavior

Figure 4.1
Monetary policy strategy and communication. (Source: Adapted from Winkler 2000)
86 Chapter 4
public, based on their understanding of the banks strategy (trans-
parency). The outcome arguably inuences the raw data that in turn
inuence the banks decisions.
Disclosure and transparency are multifaceted concepts that could
pertain to any aspect of economic policy making.
4
Thus it seems natural
to use a conceptual framework that reects the different stages of the
decision-making process. Following Geraats (2000, 2002), we distin-
guish ve aspects of disclosure: political, economic, procedural, policy,
and operational disclosure. Each may give rise to different motives for
disclosure.
Political disclosure refers to openness about policy objectives. This
comprises a statement of the formal objectives of monetary policy,
including an explicit prioritization in case of potentially conicting
goals, and quantitative targets. Political disclosure is enhanced by insti-
tutional arrangements, like central bank independence and central
bank contracts, because they ensure that there is no undue inuence or
political pressure to deviate from stated objectives.
Economic disclosure focuses on the economic information that is used
for monetary policy. This includes the economic data the central bank
uses, the policy models it employs to construct economic forecasts or
evaluate the impact of its decisions, and the internal forecasts the
central bank relies on. The latter are particularly important since mon-
etary policy actions are known to take effect only after substantial
lags. So the central banks actions are likely to reect anticipated
developments.
Procedural disclosure is about the way monetary policy decisions are
taken. It involves an explicit monetary policy rule or strategy that
describes the monetary policy framework, and an account of the actual
policy deliberations and how the policy decision was reached, which
may be achieved by, for instance, the release of minutes and voting
records.
Policy disclosure means a prompt announcement of policy decisions.
In addition it includes an explanation of the decision and a policy incli-
nation or indication of likely future policy actions. The latter is relevant
because monetary policy actions are typically made in discrete steps;
a central bank may be inclined to change the policy instrument but
decide to wait until further evidence warrants taking a full step.
Operational disclosure concerns the implementation of the central
banks policy actions. It involves a discussion of control errors in
achieving the operating targets of monetary policy and (unanticipated)
macroeconomic disturbances that affect the transmission of monetary
policy.
The index for central bank disclosure discussed in section 4.3
attempts to quantify each of these ve aspects.
4.2.2 Disclosure in Theory
Although there seems to be an unambiguous trend toward greater
openness in monetary policy, the theoretical literature on the desir-
ability of central bank disclosure and transparency is less equivocal.
5
Since the motives and consequences of disclosure may differ by aspect,
we will use the conceptual framework described above to provide an
overview of the theoretical ndings. In addition there are some inter-
esting informal discussions on the desirability of central bank open-
ness, for instance, by Buiter (1999), Issing (1999b), Goodfriend (1986),
and Winkler (2000). Buiter (1999) is an advocate of the publication of
ination forecasts because this makes it possible to evaluate the quality
of monetary policy and it increases accountability. In addition Buiter
favors the publication of individual voting records because it would
increase accountability. However, Issing (1999b) opposes the publica-
tion of ination forecasts and individual voting records. In his view,
the publication of ination forecasts could be misleading because the
public would attach more value to them than they have in the deci-
sion-making process. Issing poses that the publication of individual
voting records is not needed to communicate relevant information to
the public. Goodfriend (1986) argues that the central bank should avoid
revealing too much information to the markets that would induce extra
volatility. Winkler (2000) poses that greater openness (more informa-
tion) does not always increase the clarity of the central bank in
communication.
Political Disclosure Any uncertainty about policy makers prefer-
ences is probably reduced if the central bank provides information
about formal objectives and quantitative targets. This could be
benecial. Eijfnger and Geraats (2002) argue, for instance, that a
quantitative target, which reduces the preference uncertainty of the
central bank, could reduce the ination bias. Likewise Nolan and
Schaling (1996) show that in a static monetary policy game a reduction
in uncertainty about the central banks preference parameter for
ination stabilization reduces the ination bias; see also Cukierman
(2001b).
88 Chapter 4
According to Eijfnger et al. (2000), more uncertainty about prefer-
ences increases the ination bias because wage setters will see the
central bankers as less conservative. In addition more monetary policy
uncertainty increases the variance of the ination rate. However,
Eijfnger et al. (2000) also show that uncertainty about preferences
could be benecial when a country has a large exibility problem rel-
ative to the credibility problem because uncertainty could decrease
the variance of output. So a country facing large supply shocks may
be better off with a central banker with uncertain preferences. Eijfn-
ger et al. (2000) therefore conclude that optimal central bank secrecy
involves a trade-off between the negative and benecial effect of uncer-
tainty about monetary policy. However, Beetsma and Jensen (2003)
show that it may not be true that uncertainty about preferences is ben-
ecial, even when it is assumed that a country has a relatively large
exibility problem and faces large supply shocks. Other arrangements
that do not involve uncertainty about the preferences of the central
bankers (e.g., an ination contract or an ination target) dominate
policy with preference uncertainty. In addition Beetsma and Jensen
(2003) argue that the way in which Eijfnger et al. (2000) modeled pref-
erence uncertainty causes arbitrary effects on monetary policy. Using
their earlier preference specication (Beetsma and Jensen 1998),
Beetsma and Jensen (2003) show that preference uncertainty is always
harmful.
Quantitative targets could generate losses to monetary policy makers
when these targets are missed. Walsh (1999) shows that an explicit
ination target could reduce the ination bias for this reason. Interest-
ingly, this even holds if the target is announced by the central bank and
is not perfectly credible. In fact Walsh (1999) nds that such self-
announced targets may be preferable to an external, xed target
because it gives the central bank greater exibility to respond to private
information it has about economic disturbances.
Thornton (2002) agrees with Freedman (2002), who states that being
transparent and explicit about the ination objective and being credi-
bly committed to it is a defense against the economic and political
forces that could create an ination bias. Hughes Hallett and Viegi
(2001) argue that a lack of central bank transparency could lead to a
lower mean ination rate as a consequence of lower ination expecta-
tions but also less emphasis on output stabilization. To counteract this
effect, a less conservative government that attaches more weight to
output stabilization could be elected. Depending on which effect dom-
inates, the total effect of a lack of political central bank transparency on
ination and output is therefore unclear.
Institutional arrangements like central bank independence, central
bank contracts, and explicit override mechanisms also contribute to
political transparency because they clarify the relationship between the
government and the central bank.
The theoretical motivation for central bank independence refers to
the benets of the appointment of conservative central bankers.
The seminal paper by Rogoff (1985) shows that central bankers
that attach a greater weight to ination stabilization than socially
optimal, reduce the ination bias of monetary policy, albeit at the cost
of greater output uctuations. The latter side effect could be overcome
by the appointment of conservative central bankers with a lower ina-
tion target (Svensson 1997), or by responsible central bankers who
do not attempt to stimulate output beyond the natural rate (Blinder
1997).
Central bank contracts could not only provide quantitative targets
but also direct penalties for missing them, like nes or dismissal of the
central banker. Walsh (1995) shows that central bank contracts could
eliminate the ination bias without compromising output stabilization.
However, when there is uncertainty about the central banks prefer-
ences, Beetsma and Jensen (1998) and Muscatelli (1998) nd that the
optimal institutional setting in the form of ination targets and con-
tracts may involve a trade-off between credibility in the form of a
reduction of the ination bias, and exibility to stabilize output in
response to supply shocks. Such a credibilityexibility trade-off is
also present in the optimal override mechanism derived by Lohmann
(1992).
Economic Disclosure Most of the literature on economic trans-
parency focuses on the disclosure of economic shocks and/or central
bank forecasts. Svensson (1999) and Buiter (1999a) favor the publica-
tion of forecasts to enhance transparency and enable an evaluation of
monetary policy. When there is (mutual) uncertainty about expecta-
tions of the private sector and the central bank, Tarkka and Mayes
(1999) argue that the release of central bank forecasts could help and
make monetary policy more predictable which would decrease the
variability of output. Furthermore Geraats (2000) shows that the
publication of central bank forecasts reduces the ination bias and
facilitates reputation building when there exists uncertainty about
90 Chapter 4
the preferences of the central bank. This way the central bank
also acquires greater exibility to stabilize economic shocks. But
Geraats nds that ination forecasts typically do not sufce to reap
these benets. When a central bank uses the interest rate as its policy
instrument, central bank forecasts for both ination and output are
needed. In addition she nds that similar benets can be obtained
when the central bank releases the economic model(s) it uses for policy
analysis.
In cases where there is no preference uncertainty and a Lucas-type
transmission mechanism is present, Gersbach (1998) and Cukierman
(2001a) show that the premature disclosure of economic disturbances
can hamper their stabilization. Jensen (2001) further nds a negative
stabilization effect using a new-Keynesian Phillips curve and assum-
ing preference uncertainty.
Another reason against economic transparency is that it could lead
to greater political pressures when the central bank lacks independence
or a clear political mandate (Geraats 2001).
Procedural Disclosure The only formal models that analyze proce-
dural disclosure pertain to the release of individual voting records.
Gersbach and Hahn (2001b) show that this is benecial when central
bankers preferences may differ from the socially optimal objectives.
On the other hand, Gersbach and Hahn (2001a) argue that the disclo-
sure of attributed voting records can be harmful when central bankers
differ in their degree of competence.
To the best of our knowledge, there are no models on the desirabil-
ity of an explicit monetary policy strategy or the publication of minutes.
In defense of the latter, Buiter (1999a) strongly argues in favor of a
culture of openness and accountability such that all information is
automatically in the public domain, unless there are overriding public
interest reasons for not releasing a particular item. In this regard he
promotes the release of nonattributed minutes, since attributed, verba-
tim transcripts are likely to discourage open discussion during the
monetary policy meetings. Still the importance of minutes in enhanc-
ing transparency is disputed (e.g., see Issing 1999b). For one thing,
minutes do not reveal much because they tend to be very brief and do
not aim to make clear how the discussion evolved. The publication of
minutes can also undermine free discussion among the monetary
policy board members, and where central banks have a clear collective
responsibility, the usefulness of making voting behavior public may be
limited. Publication can even undermine the credibility of a decision
taken by only a slight majority and put pressure on presidents of
national central banks.
Policy Disclosure Several papers analyze the effects of a prompt
announcement of the policy decision, and they all focus on (nonbor-
rowed) reserves targeting. Tabellini (1987) shows that when there is
uncertainty about the average reserves target, secrecy about the short-
term reserves target increases volatility of the federal funds rate, which
could be detrimental to the achievement of monetary objectives. In con-
trast, Dotsey (1987) argues that secrecy about the short-term monetary
target reduces variability of the federal funds rate when the average
money target is perfectly known. In addition Rudin (1988) nds that
such policy secrecy could increase the predictability of the federal
funds rate when some private sector agents engage in Fed watching.
Finally Cosimano and Van Huyck (1993) nd that secrecy about policy
directives for reserve targets is benecial when the central banks
trading desk has an incentive to manipulate reserves to reduce the
federal funds rate.
The consequences of immediate policy explanations and indications
of policy inclination have, as far as we know, not been formally
modeled.
Operational Disclosure An inuential precursor to the transparency
literature is Cukierman and Meltzer (1986) on the optimal degree of
ambiguity in monetary policy through control errors when the central
banks preferences are uncertain and change over time. Faust and
Svensson (2001) extend their model and distinguish between imperfect
monetary control and (operational) transparency. In their model high
transparency generally reduces the ination bias and improves social
welfare. It is assumed that the central bank controls ination imper-
fectly and that the central bank has an employment target which varies
over time according to an idiosyncratic component. By revealing the
control error over ination, the central bank renders its intentions for
ination observable, which results in lower ination as it increases the
sensitivity of a central banks reputation to its actions, making it more
costly for the central bank to pursue a high ination policy. In the Faust
and Svensson (2001) model there is also a regime (called the extreme
transparency regime) in which both the central banks employment
goal and its ination intentions are observable. In this situation the
92 Chapter 4
central banks reputation is no longer affected by its actions, and an
inationary bias brings ination to a higher level. Faust and Svensson
(2000) argue that minimum transparency is likely to occur in practice
when the degree of transparency is a choice variable for the central
bank.
Jensen (2001) nds that greater operational transparency can be ben-
ecial when central banks suffer from low credibility, but that it limits
the ability to stabilize economic disturbances in the case of a new-
Keynesian Phillips curve. In his model, openness about control errors
worsens the current inationoutput trade-off. The central bank
attempts to create surprise ination when the output goal is high. The
scope for this is reduced by greater operational transparency because
of the increase in forward-looking ination expectations. The assump-
tion made is that information about these control errors or shocks is
disclosed before current ination expectations are set so that it affects
the current inationoutput trade-off.
This leaves us with the question of whether central bank disclosure
is desirable. Clearly, it depends on which aspect of disclosure is con-
sidered. But even then, there is a wide variety of theoretical arguments
regarding the economic consequences, depending on the specic
assumptions used. Ultimately the answer may be that it depends on
the type of disclosure considered, the monetary framework and the
structure of the economy. Nevertheless, from the perspective of demo-
cratic accountability of monetary policy, which is especially desirable
in the case of independent central banks, some degree of disclosure
is simply necessary. In this respect, possible economic drawbacks of
disclosure could be considered as the price that society may need to
pay for accountability.
4.2.3 Effects of Disclosure: Empirical Evidence
The issue of the economic consequences of disclosure and transparency
has received only scant attention in the empirical literature (see Posen
2003 for a discussion). Many policy makers argue that disclosure (or,
as they often call it, transparency) can strengthen the effectiveness of
monetary policy making. According to Issing (2001a, p. 13), trans-
parency imposes discipline on policy makers and is a means to ensure
a general understanding of the monetary policy strategy. In turn, this
may add to the credibility, and thereby the effectiveness, of monetary
policy, hence facilitating the central banks effort to attain its statutory
objective.
Indeed, Chortareas et al. (2002) nd for a sample of 87 countries that
their index of disclosure (based on data taken from Fry et al. 2000),
which is based on central banks published forecasts and ranges from
zero to four, is negatively related to average ination, also if various
control variables are taken up. However, using the Eijfnger-Geraats
disclosure index for 9 OECD countries, as discussed in the next section,
Demertzis and Hughes Hallett (2002) conclude that disclosure does not
affect the levels of ination and output, although it does affect their
variability.
Another reason that transparency matters is that communication by
the central bank about its long-term ination goal allows the bank to
be more exible in response to shocks in the short run. The trust in the
central bank resulting from communication implies that deviations
from the target do not indicate a lack of commitment (King 1997). If
the central bank builds trust by communicating its long-term ination
objective, ination persistence will decline since there is a strong belief
that ination will return to a target level. There is evidence in support
of this view. Kuttner and Posen (1999) examine the behavior of bond
markets (proxying for ination expectations) in Canada, New Zealand,
and the United Kingdom before and after the central banks in these
countries adopted ination targeting. They nd that interest rates
decreased consistent with the view that the adoption of ination
targeting increases exibility. Kutner and Posen (2001) report similar
results for a broader range of countries: ination targeting reduces
ination persistence, in contrast to other elements of the monetary
framework, like central bank independence. However, Ball and Sheri-
dan (2003), who compare 7 OECD countries that adopted ination
targeting in the early 1990s to 13 that did not, report no supportive
evidence. They nd that after the early 1990s, performance improved
in both the targeting and nontargeting countries. Where targeters
improved by more than nontargetters this is explained by the fact that
targeters performed worse than nontargeters before the early 1990s,
and there is regression to the mean. Once regression to the mean is
taken up, there is no evidence that ination targeting improves
performance.
Chortareas et al. (2003) investigate the effect of central bank trans-
parency on the costs of disination. They assume that disination
efforts imply a higher sacrice ratio when the public is not fully con-
vinced that the central bank will reduce ination. Chortareas et al. esti-
mate sacrice ratios for 21 OECD countries and use disclosure indexes
94 Chapter 4
relating to the detail with which forecasts are published and the means
by which policy decisions are explained. Their results suggest that
when the degree of central bank disclosure is higher, the sacrice ratio
is lower. This result is robust to alternative estimation methods and
periods considered.
A nal reason why transparency may matter is that communication
may remove noise from markets (Posen 2003). Greater disclosure
will lead to greater predictability of central bank actions. The results
reported by Kuttner (2001) offer support for this point of view. Changes
in the Federal Reserves disclosure policy have reduced market volatil-
ity and increased predictability.
4.3 Transparency of the ECB
Various indicators for central bank disclosure have been suggested in
the literature. The indicator of Eijfnger and Geraats (2002) is discussed
in some detail in this section.
The central bank disclosure index of Eijfnger and Geraats (2002) is
the (nonweighted) sum of the scores for the answers to a number of
questions discussed below. The minimum score is 0; the maximum
score is 15. The index consists of 5 classications of disclosure, while
each classication includes 3 items. Note that all questions pertain to
published information that is freely available in English as of June 2001.
The index consists of the scores for nine central banks: the Reserve Bank
of Australia, the Reserve Bank of Canada, the European Central Bank,
the Bank of Japan, the Reserve Bank of New Zealand, the Sveriges
Riksbank, the Swiss National Bank, the Bank of England, and the
Federal Reserve System. The index is based on the various aspects of
disclosure as distinguished in the previous section. Table 4.1 presents
the scores for the various central banks.
In the table political disclosure refers to openness about policy objec-
tives. This comprises a formal statement of objectives, including an
explicit prioritization in case of multiple goals, a quantication of the
primary objective(s), and explicit institutional arrangements. It is quan-
tied by the following questions:
Is there a formal statement of the objective(s) of monetary policy, with

an explicit prioritization in case of multiple objectives?
Is there a quantication of the primary objective(s)?

T
r
a
n
s
p
a
r
e
n
c
y
,

A
c
c
o
u
n
t
a
b
i
l
i
t
y
,

a
n
d

C
r
e
d
i
b
i
l
i
t
y

o
f

t
h
e

E
C
B
9
5
Table 4.1
Eijfnger-Geraats index of central bank disclosure
Euro New United United
Australia Canada area Japan Zealand Sweden Switzerland Kingdom States
Political disclosure 3 3 3 1.5 3 3 2.5 3 1
Formal objectives 1 1 1 0.5 1 1 0.5 1 0.5
Quantitative targets 1 1 1 0 1 1 1 1 0
Institutional arrangements 1 1 1 1 1 1 1 1 0.5
Economic disclosure 1 2.5 2.5 1.5 2.5 2 1.5 2.5 2.5
Economic data 0.5 1 1 1 0.5 1 1 0.5 1
Policy models 0 1 1 0 1 0 0 1 1
Central bank forecasts 0.5 0.5 0.5 0.5 1 1 0.5 1 0.5
Procedural disclosure 1 1 1 2 3 2 1 3 2
Explicit strategy 1 1 1 0 1 1 1 1 0
Minutes 0 0 0 1 1 1 0 1 1
Voting records 0 0 0 1 1 0 0 1 1
Policy disclosure 1.5 2 1.5 1.5 3 2 2 1.5 3
Prompt announcement 1 1 1 1 1 1 1 1 1
Policy explanation 0.5 1 0.5 0.5 1 1 1 0.5 1
Policy inclination 0 0 0 0 1 0 0 0 1
Operational disclosure 1.5 2 2 1.5 2 3 0.5 2.5 1.5
Control errors 1 1 1 0.5 1 1 0.5 1 1
Transmission disturbances 0.5 0.5 0.5 0.5 0.5 1 0 1 0
Evaluation policy outcome 0 0.5 0.5 0.5 0.5 1 0 0.5 0.5
Total 8 10.5 10 8 13.5 12 7.5 12.5 10
96 Chapter 4
Are there explicit institutional arrangements or contracts between the

monetary authorities and the government?
As follows from table 4.2, almost all central banks have three points.
The exceptions are the Bank of Japan, the Swiss National Bank, and
the Federal Reserve. These central banks dont earn the full score on
the rst question, since they have multiple objectives of monetary
policy without prioritization. Furthermore the Bank of Japan and the
Federal Reserve have no quantication of the primary objectives of
monetary policy, so they earn no points under the second question.
Finally, the Fed does not have explicit instrument independence or a
contract and therefore it receives only 0.5 point under the third
question.
Economic disclosure refers to the economic information used for mon-
etary policy. This includes economic data, the model of the economy
that the central bank employs to construct forecasts or evaluate the
impact of its decisions, and the internal forecasts (model based or judg-
mental) that the central bank relies on. It is quantied by the following
questions:
Is the basic economic data relevant for the conduct of monetary

policy publicly available? The focus is on the following ve variables:
money supply, ination, GDP, unemployment rate, and capacity
utilization.
Does the central bank disclose the formal macroeconomic model(s)

it uses for policy analysis?
6
Does the central bank regularly publish its own macroeconomic

forecasts?
The results for economic disclosure are very mixed. No central bank
earns the full score. Five central banks have the highest score, that is
2.5 points (the Bank of Canada, the ECB, the Reserve Bank of New
Zealand, the Bank of England, and the Federal Reserve). These central
banks loose 0.5 point on either publishing only quarterly time series
for three or four out of the ve variables requested under the rst ques-
tion above or publishing numerical central bank forecasts for ination
and/or output at less than quarterly frequency. The Reserve Bank of
Australia and the Sveriges Riksbank both have the lowest score, which
is 1 point. The Reserve Bank of Australia reaches this score since it pub-
lishes only quarterly time series for four out of the ve variables
requested under the rst question; therefore it receives only 0.5 point.
Furthermore it is unclear whether the Reserve Bank of Australia uses
a formal macroeconomic model for policy analysis. Finally the Reserve
Bank of Australia only publishes a rough short-term ination projec-
tion; therefore it earns only 0.5 point under the rst question.
Procedural disclosure is about the way monetary policy decisions are
taken. It involves an explicit monetary policy rule or strategy that
describes the monetary policy framework, an account of policy delib-
erations and how the policy decision was reached. It is quantied by
the following questions:
Does the central bank provide an explicit policy rule or strategy that
describes its monetary policy framework?
Does the central bank give a comprehensive account of policy delib-

erations (or explanations in case of a single central banker) within a
reasonable amount of time?
Does the central bank disclose how each decision on the level of its
main operating instrument or target was reached?
Only the Reserve Bank of New Zealand and the Bank of England get
the full score for procedural disclosure. The Bank of Japan, the Sveriges
Riksbank, and the Federal Reserve Bank all earn 2 points. Both the Bank
of Japan and the Federal Reserve loose 1 point under the rst question
above, since they dont provide an explicit policy rule or strategy that
describes its monetary policy framework. The Sveriges Riksbank earns
no points under the last question above, since it has no actual voting
records available.
Policy disclosure means prompt disclosure of policy decisions. In
addition it includes an explanation of the decision, and an explicit
policy inclination or indication of likely future policy actions. It is quan-
tied by the following questions:
Are decisions about adjustments to the main operating instrument or

target promptly announced?
Does the central bank provide an explanation when it announces

policy decisions?
Does the central bank disclose an explicit policy inclination after

every policy meeting or an explicit indication of likely future policy
actions (at least quarterly)?
The results for policy disclosure show that only the Reserve Bank of
New Zealand and the Federal Reserve earn 3 points. The Bank of
98 Chapter 4
Canada, the Sveriges Riksbank and the Swiss National Bank get 2
points, making them second best. All three central banks earn 0 points
under the third question, since they do not provide an explicit indica-
tion of their policy inclination or likely future policy actions, although
the Swiss National Bank gives its expectations for the future. The
remaining central banks loose another 0.5 point, since they only
provide an explanation for policy decisions when policy decisions
change. Their scores are 1.5 points.
Operational disclosure concerns the implementation of the central
banks policy actions. It involves a discussion of control errors in
achieving operating targets and (unanticipated) macroeconomic dis-
turbances that affect the transmission of monetary policy. Furthermore
the evaluation of the macroeconomic outcomes of monetary policy in
light of its objectives is included here as well. It is quantied by the
following questions:
Does the central bank regularly evaluate to what extent its main
policy operating targets (if any) have been achieved?
Does the central bank regularly provide information on (unantici-

pated) macroeconomic disturbances that affect the policy transmission
process?
Does the central bank regularly provide an evaluation of the policy

outcome in light of its macroeconomic objectives?
The results for operational disclosure are very mixed. Only the Sveriges
Riksbank earns the full score. The Bank of England is second best with
2.5 points. It looses 0.5 point under the rst question above, since it
provides an evaluation of the policy outcome only casually and
without providing explanations for deviations. The Swiss National
Bank has the worst score, only 0.5 points, earned under the same ques-
tion. It has an operational target range of 100 basis points for three-
month LIBOR rate, but it does not provide an explanation for the
signicant uctuations within the target. Furthermore it has only a
brief abstract of the analysis of macroeconomic disturbances that affect
the policy transmission process available in English. Finally, the Swiss
National Bank does not account for discrepancies between policy
outcome and target.
The disclosure index of Eijfnger-Geraats consists of the overall score
for each central bank. The Reserve Bank of New Zealand has the
highest rating, that is 13.5 points, while the Sveriges Riksbank is second
best with 12 points. The central bank with the lowest score is the Swiss
National Bank, with only 7.5 points.
It follows from table 4.2 that in terms of information being provided
and activities undertaken to distribute this information, the ECB scores
comparatively high. In fact the ECB is as open as the Federal Reserve.
One obvious objection that is often raised against indictors like this is
that they are rather arbitrary andto a certain extentsubjective. To
check whether our conclusion on ECB disclosure is sensitive with
respect to the measure chosen, we show in sidebar 7 similar indicators
of Gros and Bini-Smaghi (2001), Siklos (2002), and of De Haan and
Amtenbrink (2002). We also show the results for the indicator of Fry
et al. (2000), even though this indicator is not available for the ECB.
It clearly follows that most indicators come up with a very similar
ranking of the ECB. The exception is Siklos (2002), who gives the
ECB the lowest ranking of the banks under consideration here. That
outcome is remarkable because Siklos (2002) takes many of the same
issues into account as the other authors and uses similar indicators. On
closer inspection it turns out that the low score for the ECB on the Siklos
indicator is the result of the relatively high weight of the items pub-
lication of minutes of central bank meetings and publication of com-
mittee voting record (on which the ECB scores zero) and a low weight
on items like publication of reports, regular speeches on which the ECB
gets the highest score possible.
7
So far the analysis suggests that the ECB has a relatively high score
on disclosure.
8
There are, however, indications that nancial markets
do not have a good understanding of the ECBs strategy and face con-
siderable uncertainty over monetary policy. Because the policies of the
ECB are often considered to be unclear, Issing (2000) concludes that the
ECB faces a communication gap:
On the one hand, few observers contest the success and credibility of the ECB
in delivering on its primary objective and on the appropriateness of most of
its policy actions in this regard. . . . On the other hand, however, the overall
perception of the ECB by the public, academics, nancial analysts, market
participants, and not least, journalists continues to remainat bestrather
mixed.
The ECB also did not perform well, in a survey by Goldman Sachs
taken in February 2000. In this survey nancial market participants
were asked to rate on a scale of 1 to 5 how well they understood the
reasoning behind monetary policy decisions of four central banks (a
7 Other Indicators of Central Bank Disclosure
This sidebar summarizes the scores of various central banks according
to some other disclosure indicators. We start with the index of De Haan
and Amtenbrink (2002). This indicator consists of 14 questions, which, if
answered in the afrmative, yield either 1 or 2 points (see table 4.2). The
rst group of criteria relates to the objectives of monetary policy. If the
law and/or central bank documents clearly stipulate the objectives of
monetary policy a score of 1 is assigned. If the law or some central bank
document identies clear priorities with regard to different objectives a
score of 1 is given. Likewise, when there is a clear denition and time
horizon and when a quantication of the objective(s) is given (either in
some legal document or some ofcial document from the bank), a score
of 1 is given for criteria 3 to 5. The second group of criteria relates to the
strategy of the central bank to reach the ultimate objective(s). If the strat-
egy is clearly announced, a score of 2 is assigned. If the decision of the
central bank on interest rates is immediately announced and if there is,
as a rule, a supporting statement explaining the decision on the basis of
the central banks strategy, the score is 2 on criterion 7. A value of 2 is
given for criterion 8 for clear quantied forecasts of the decision-making
unit of the central bank, and a value 1 for projections because these are
not underwritten by the central banks decision-making unit. The nal
group of criteria refers to the procedures followed by the central bank to
effectively communicate with the public. For criterion 9 a score of 2 is
assigned if the governor of the central bank appears before the Parlia-
ment at least three times a year; the score is 1 in case of one to three
annual hearings before Parliament, and zero otherwise. When the central
bank publishes a report on a monthly basis, a value of 2 is assigned for
criterion 10, a value of 1 in case of quarterly reports, and 0 otherwise. If
the schedule of meetings of the policy-making unit is publicly available
in time so that it is clear when policy decisions will be taken, De Haan
and Amtenbrink (2002) assign a value of 1 for criterion 11. Two points
are given for criterion 12 if press conferences are held in regular inter-
vals (monthly) and regular press releases are issued. A value of 1 is
assigned if only one of the two is featured and a value of 0, if neither
exists. A value of 1 is assigned to criterion 13 when the minutes of the
policy-making bodies are released within a reasonable time. Similarly a
value of 1 is given for criterion 14 if votes of members of the decision-
making body are released (with a certain lag). Both the subcategories and
the total score with and without the issues related to minutes and infor-
mation on voting behavior are given.
The indicator of De Haan and Amtenbrink (2002) is inspired by a
similar index of Gros and Bini-Smaghi (2001). The total score of this index
is also shown in table 4.2. Finally, the index of Fry et al. (2000) is shown,
although it is not available for the ECB. This index is based on a survey
of central banks that provides estimates of many characteristics of
disclosure. This indicator ranges from zero (minimum disclosure) to
hundred.
Table 4.2
Disclosure indicator of De Haan and Amtenbrink compared with other indicators
Reserve
Federal Bank
Reserve New Bank of Bank of Deutsche
ECB System Zealand Canada England Bundesbank
Objectives 4 1 5 5 5 3
1 Clear objectives 1 1 1 1 1 1
2 Clear priorities 1 0 1 1 1 1
3 Clear denition 1 0 1 1 1 1
4 Clear time 0 0 1 1 1 0
horizon
5 Quantication 1 0 1 1 1 0
Strategy 5 3 6 6 5 3
6 Announcement of 2 0 2 2 2 2
strategy
7 Interest rate 2 2 2 2 1 1
decision
immediately
announced and
always explained
8 Ination forecast 1 1 2 2 2 0
Communication 7 7 6 6 8 4
strategy
9 Parliamentary 2 1 2 2 2 0
hearings
10 Frequency of 2 2 1 1 1 2
reports
11 Meeting schedule 1 1 1 1 1 1
12 Press conferences/ 2 1 2 2 2 1
press releases
13 Publication of 0 1 NA
1
0 1 0
minutes
14 Publication of 0 1 NA 0 1 0
individual votes
Total 16 11 17/19 17 18 10
Subtotal (112) 16 9 17 17 16 10
Gros and Bini-Smaghi 19 (19) 16 (14) n.a. 15 (15) 24 (20) 13 (13)
index
Siklos index 0.52 0.87 0.83 0.83 0.91 0.70
Index of Fry et al. NA 95 92 79 94 70
Eijfnger and Geraats 10 10 13.5 10.5 12.5 NA
index
102 Chapter 4
higher grade indicates a better understanding). Table 4.3 shows the
results.
The respondents gave the US Federal Reserve a top rating of 4.3. Fur-
thermore votes were relatively highly concentrated on the two top
ratings. Right behind the Fed come the German and British central
banks with average scores of 3.5 and 3.3, respectively. Note that in these
cases there was quite some dispersion around the mean. The ECB
ranked lowest with an average score of just 2.2.
Of course, one objection that can be raised against the results
reported in table 4.3, is that at the time of the survey the ECB had just
been created. For this reason, we re-examined the issue, using more
recent information. As part of a survey, which is explained in more
detail in section 4.6 and which primarily focuses on the credibility of
central banks, we asked our respondents (professional economists) to
rank seven central banks according to their transparency. The results
are presented in table 4.4.
Table 4.3
Transparency ratings of central banks according to a survey by Goldman Sachs
Distribution of ratings (in %)
1 2 3 4 5 Average
Federal Reserve 0.0 1.8 7.1 48.7 42.5 4.3
Bank of England 5.5 10.0 42.7 33.6 8.2 3.3
Bundesbank
a
2.7 10.0 35.5 38.2 13.6 3.5
ECB 21.2 43.4 27.4 7.1 0.9 2.2
Source: Goldman Sachs, as reported in Gros et al. (2000).
a. Until 1999.
Table 4.4
Rankings of central banks in terms of their transparency
Central Bank Transparency
Banca dItalia 6.17 (0.94)
Bank of England 3.33 (1.38)
Bank of Japan 5.93 (1.24)
Banque de France 4.86 (1.04)
Deutsche Bundesbank 2.63 (1.24)
European Central Bank 3.17 (1.50)
Federal Reserve 1.66 (1.21)
Two conclusions can be drawn. First, the results on (perceived) trans-
parency by our respondents are broadly in line with the results pre-
sented in table 4.3. The Federal Reserve and the former Deutsche
Bundesbank were clearly perceived as more transparent than the ECB.
Second, the Bank of Englandwhich according to the disclosure indi-
cators of Eijfnger and Geraats (2002) and De Haan and Amtenbrink
(2002) was expected to be very transparenthad a similar score to that
of the ECB in both surveys.
How can the discrepancy between the high degree of disclosure and
the public perception of the ECBs transparency be explained?
9
A pos-
sible cause for the low score on perceived transparency may be found
in the quality of the information being provided. As pointed out by the
IMF (2000a), transparency requires more than just making information
available about policy objectives, responsibilities, policy decisions, and
performance results. The content of disclosure is critical for the efcient
functioning of markets, and its importance will only increase with the
evolving changes in international trading and nancing arrangements
and sophistication of markets. Failure to present public statements and
reports on monetary policy issues with appropriate content can under-
mine the credibility of central banks and result in corresponding
behavior by the nancial markets, thereby negatively inuencing the
outcome of monetary policy (see gure 4.1). The focus of disclosure
should therefore be on the materiality and relevance of the information
that is being provided to the public. The objective of transparency
would, for example, not be met by the release of reports that offer con-
tradictory assessments. The same holds true for contradicting public
statements by the members of the decision-making organs of the
central bank, something that the ECB has been criticized for in the past
and sometimes rightly so (see also sidebar 8). For instance, at about the
same time that ECB President Duisenberg announced in the European
Parliament that the ECB would publish ination forecasts, Issing
(1999b) argued that the ECB would not do so.
10
Similarly, not applying disclosure consistently (e.g., reversals of pre-
viously applied practices when developments are unfavorable), would
defy the spirit and intent of transparency and could moreover weaken
credibility.
Often the low degree of ECB transparency is related to the monetary
policy strategy of the ECB. Begg et al. (2000, p. 25) nd, for example,
that Our observations of ECBs deeds and words in 1999 . . . suggest
that much remains to be done to communicate the precise meaning
104 Chapter 4
8 Communicating about the Euro
Why would ECB ofcials communicate about the eurodollar exchange
rate? We see at least three reasons. First, there has been confusion about
the role of the exchange rate in the monetary policy strategy of the ECB.
Sometimes it is thought that the ECB has an exchange rate objective,
which it does not. However, the ECB closely watches the external value
of the euro under what it now called the economic analysis (the second
pillar) because exchange rate shocks can cause ination in the euro area
(see section 3.6).
A second reason why the ECB closely follows exchange rates is that
there is always a risk that exchange rates will fall out of sync with fun-
damentals, whatever they may be. By communicating these worries
about developments in the exchange rate, the ECB can try to affect the
external value of the euro.
Athird reason why ECB ofcials have made exchange rate projections
is to quell the anxieties of the public about the decline of the euro after
the start of the monetary union. Politicians and central bankers had
declared that the euro was to be a strong currency, but the external weak-
ness of the euro was often seen to contrast with this claim. Therefore ECB
ofcials kept on re-assuring the public that the decline of the euro was
no sign of a weak currency.
ECB ofcials have not always been clear in their communication about
the role of the euro in the ECB policies. For instance, in April 1999
Duisenberg said to the European Parliament: Not having an exchange
rate policy, and we have no policy, does not mean that there is benign or
malign neglect. For the time being, there is neglect. Eight days later
Duisenberg tried to undo the damage, stating that the ECB does not
neglect the euro exchange rate. These and other such instances led Sims
and Wessel (2000) to the conclusion that The European Central Bank
Cant Master Communication.
The frequency of ofcial communications by ECB ofcials is also quite
remarkable. Table 4.5 is reproduced from Jansen and De Haan (2003). It
indicates the extent to which some central bankers go to seek publicity.
Notably the comments of the president of the Bundesbank and other of-
cials of the German central bank are more often given coverage in the
news than those of other central banks.
of the announced monetary policy strategy. Unless the ECB claries
its intentions it will take timepossibly a lot of timefor outside
observers to form a clear view. We have discussed this issue already
in chapter 3, where we concluded that another monetary policy strat-
egy is likely to enhance the transparency of the ECB.
Another factor that has received scant attention in the literature so
far is the role of media.
11
As shown in gure 4.1, the public depends to
a large extent on the information they receive through the media. It
becomes thus interesting to see how the media portray ECB policy deci-
sions. In particular, the media may not necessarily fully reect the deci-
sions taken by the central bank nor delve into the reasoning behind
them. Sidebar 9 reports some preliminary outcomes of a project in
which reports on monetary policy decisions by two major European
newspapers are critically evaluated. Clearly, part of the gap between
the ECBs efforts to provide transparency and the public perception of
its inadequacy in this regard may be due to the selective way that
media reporters cover monetary policy issues. Differences in reporting
style on monetary policy issues by the newspapers are notable. The
explanation seems to lie not only in differences of political orientation
but, more important, in a different understanding of the role of the
ECB.
Table 4.5
Look who is talking about the euro
Positive Neutral Negative Total
Groups
Executive Board 149 72 35 256
National central bank presidents 203 69 64 336
BundesBank ofcials (excluding president) 34 30 18 82
Total 386 171 117 674
Individuals
Duisenberg 48 27 17 92
BundesBank president 99 45 35 179
Tietmeyer
a
17 6 1 24
Welteke
b
82 39 34 155
Trichet 72 13 10 95
Source: Jansen and De Haan (2003).
Note: Positive/negative means a statement expected to have an appreciating/
depeciating effect on the euro (e.g., a hint that interest rate may rise/decline).
a. January 4, 1999, until October 31, 1999.
b. September 1, 1999, May 17, 2002.
106 Chapter 4
9 Are Newspaper Reports on the ECB Biased?
De Haan and Amtenbrink (2002) examine newspaper reports published
one day after the Governing Council of the ECB took a certain policy
decision in 1999 and likewise in 2000 in the Financial Times (FT) and in
the Frankfurter Allgemeine Zeitung (FAZ).
First, with a few exceptions, the reports in the FT and FAZ are correct
in their content. Second, relatively little attention is paid to money
growth in the FT, in sharp contrast to the FAZ. In instances where some-
thing is written about the rst pillar of the ECB monetary policy strat-
egy, the FT tends to be critical while the FAZ clearly supports the idea
that money should be given a prominent role in the strategy of the ECB.
An excellent example occurred in December 1999 when the ECB
announced that it would keep the reference value for M3 growth at 4.5
percent. At the press conference where this was announced, President
Duisenberg of the ECB criticized the German government for support-
ing the German construction company Phillipp Holzmann, which at the
time was at the brink of bankruptcy; the remark was made within the
context of a weakening euro. The FT had three reports on the ECB on
December 3, 1999, but did not pay much attention to the banks decision
on the reference value for M3; it instead focused on Duisenbergs remarks
on the German support for Holzmann. This stands in sharp contrast to
the way in which the FAZ reported on the press conference. The article
in the FAZ started with the decision by the ECB Governing Council to
keep the reference value at 4.5 percent and the reasoning behind this
decision. Only at the very end of the report, after a description of what
Duisenberg said about the euro and foreign exchange intervention, and
within the proper context, did the FAZ mention Duisenbergs criticism
of the German government.
This example also illustrates a third characteristic of FT reporting on
ECB matters: a strong focus on (alleged) disagreements with govern-
ments, the OECD, IMF, oreven more stronglywithin the ECB. Very
often decisions are disclosed in terms of victory for certain members of
the Governing Council. Agood illustration in this respect is the FT report
on November 5, 1999, in which it is stated that the Bundesbank was
opposed to an early rise of interest rates because Germanys recovery
was less strong than in other euro-zone countries, thereby implying that
national instead of euro-areawide considerations are a dominant factor
in the Governing Council decision-making process.
The FT reports almost always express whether the decision by the ECB
was in line with nancial markets expectations. Any hint for future
changes of interest rates are spelled out at length. The FAZ pays some-
what less attention to these points.
A strong focus on the euro is another characteristic of FT reports on
policy decisions. The consequences for the eurodollar exchange rate of
decisions (not) to change interest rates are stressed. In fact it is often sug-
gestedand sometimes stated explicitlythat policy decisions are taken
in view of the weak position of the euro. In this respect the FT reports,
and particularly the headlines, have been unbalanced and even wrong.
For example, in the headline as well in the interior part of the report on
February 4, 2001, there was stated that the ECB increased rates to support
the euro. The ofcial ECB press release rather stated that: [T]hese deci-
sions were taken on the basis of an assessment of the risks to price sta-
bility in the medium term in the context of the Eurosystems monetary
policy strategy. Considering the rst pillar of this strategy, both mone-
tary and credit growth continue to signal generous liquidity conditions.
. . . As for the second pillar of the monetary policy strategy, price and cost
increasesincluding oil and nonenergy commodity prices as well as pro-
ducer priceshave been larger and more protracted than foreseen earlier
and hence indicate the risk of second round effects. . . . The deprecia-
tion of the euro which we have witnessed is contributing to increases in
import prices. In other words, the rise was motivated by price stability
considerations and not by the weakness of the euro, as suggested by the
report in the FT. Again, a comparison with the report in the FAZ shows
major differences. The FAZ reported that interest rates were increased as
the risks for price stability increased stronger than expected, suggesting
that: [I]n this context the weakness of the euro also plays a role.
In effect, the FT is more critical in reporting on the ECB than the FAZ.
This is not to say that the FAZ is not ever critical. It has especially criti-
cized severely the lack of a transparent policy with respect to the exter-
nal value of the euro, but over all, on a good number of occasions the
FAZ has demonstated full support for the two-pillar strategy of the ECB.
This includes the ECBs strong focus on money growth, which the FT
does not support.
Also the differences, especially in newspaper editorials, on the impor-
tance of wage moderation, labor market reform, and scal policy are
remarkable. Whereas the FAZ does not criticize the ECBs views on these
issues, the FT is more critical, and hones in if the ECB goes beyond a plea
for decit reduction and instead indicates how consolidation should be
done.
108 Chapter 4
4.4 Accountability of the ECB
The European Central Bank (ECB) is widely considered to be a politi-
cally independent institution. One potential objection toward a com-
pletely independent central bank is lack of democratic accountability
(e.g., see Stiglitz 1998). In this section we rst outline the concept of
democratic accountability. We then compare the legal accountability of
the ECB with those of some other central banks (Bank of Canada, Bank
of Japan, Bank of England, and the Federal Reserve System).
12
The Oxford English Dictionary denes accountable as obliged to give
a reckoning or explanation for ones actions; responsible. So, contrary
to what Issing (1999b) seems to say, accountability refers not only to
the question of whether a central bank has achieved its mandate but
also to what the central bank has done in attempting to achieve this
mandate. It does not make sense to state that accountability refers to
deeds and transparency to words. Since interest rate changes (deeds)
are easily observed, what matters is an explanation to the entities to
which a central bank is accountable why a certain decision is made
(words). The latter refers to accountability.
How can this general concept be made operational in relation to
central bank accountability? In our view the concept of central bank
accountability has three main features:
1. Decisions about the explicit denition and ranking of objectives of mon-
etary policy.
2. Disclosure of actual monetary policy.
3. Who bears nal responsibility with respect to monetary policy.
In a democratic society it is up to elected politicians to decide on the
explicit denition and ranking of objectives of monetary policy. Why should
decisions on the objectives of this form of economic policy be treated
differently than those of other forms of economic policy, such as scal
policy? Indeed, it is widely believed that only elected representatives
should decide on tax laws and government spending. It is therefore
questionable whether it is legitimate in a democratic system to leave
the decisions on the objectives of monetary policy in the hands of an
independent institution that is not subject to elections or ministerial
responsibility.
Clearly, monetary policy objectives should be dened. As we showed
in chapter 2, the primary objective of the ECB (i.e., to maintain price
stability) is no where precisely specied in primary Community
law. In the current setting it is left to the ECB to provide an opera-
tional expression of this primary objective. Any institutionbe it the
European Parliament or some other entitycharged with holding the
central bank accountable is therefore strictly not provided with an
effective statutory yardstick by which to evaluate the performance of
the ECB, and thus cannot hold the bank accountable for its conduct of
monetary policy.
The choice of a single objective, of course, simplies the monitoring
of central bank performance. The announcement of a single goal (or a
primary goal), rather than several unranked goals, enables authorities
and public opinion to effectively follow an institutions performance.
In this sense the Treaty on European Union (TEU) and the Statute of
the European System of Central Banks and of the European Central
Bank are very clear: they provide a hierarchy of goals. This is, in our
view, a sensible thing to do. In contrast, the Federal Reserve System
faces multiple conicting objectives (maximum employment, stable
prices, and moderate long-interest rates), and neither the Federal
Reserve Act nor any other law provides any hierarchy.
Agood example of a central bank with a clear prescription of objec-
tives is the Reserve Bank of New Zealand, which has the pursuit of
price stability as its primary objective. The governor of the Reserve
Bank of New Zealand has to agree with the government a tight target
range for ination. The document that denes the target range for the
ination rate is called a Policy Target Agreement (PTA). We advocate
this system with its clearly dened a target range for the ination rate
for European monetary policy arrangements as well.
Disclosure is also an important component of accountability. Central
bank ofcials can be held accountable for their behavior where the rea-
soning behind and strength of opinion supporting certain monetary
policy decisions are clear. A central bank should be required to report
at regular intervals on its past performance and future plans for
monetary policy in accordance with some monetary objective. This is
especially necessary where no clear monetary objective exists because
then the central bank must be judged on the basis of its statements
alone. As disclosure should not be at the discretion of the central
bank, the law must prescribe certain procedures about explaining
monetary policy. There are various ways to do this, ranging from
reports, to minutes, to other communication devices. Legally the
ECB is compelled to publish a quarterly statement of its activities.
110 Chapter 4
Whether and to what extent these statements include details of past
performance, or future monetary policy plans is, again, left to the ECB
to decide. The TEU and ECB statute do not specify the contents of these
reports.
Concerning the nal responsibility for monetary policy, we think that
three issues are crucial: the ECBs relationship with the European
Parliament, the introduction of an override mechanism, and a dis-
missal procedure for the European Central Banks governor.
The relationship between a central bank and parliament has to play
a major role in any evaluation of the democratic accountability of a
central bank. There should be a legal requirement for the central bank
to report and/or explain its policy actions to parliament. Parliament
should have the opportunity to review the performance of the central
bank on a regular basis so that the central bank can at the same time
explain and justify its operations accordingly. Apart from the obliga-
tory presentation of an annual report by the president of the ECB, the
European Parliament could ask the members of the Executive Board to
appear before Parliament as well. The ECB has gone some way in this
direction as the president of the ECB has expressed his willingness to
appear before the European Parliament at least four times a year in
addition to his presentation of the annual report.
We fully agree with Buiter that it is essential that the European Par-
liament act as an effective watchdog over the ECB. The legitimacy of
the ECB will depend on the extent to which it is effectively account-
able to the European Parliament (Buiter 1999a, p. 200). We would even
like to go a step further. It has been argued in the context of national
central banks in general that parliament always holds the ultimate
responsibility for monetary policy because it can change the legal basis
of the central bank. Indeed, the mere threat of a change of law can
ensure that independent central banks (e.g., the Bundesbank) will
behave in general in accordance with the wishes of elected politicians
(Gormley and De Haan, 1996). However, the power of national parlia-
ments with respect to the legal basis of the ECB is quite limited. Any
change must require an amendment to the primary Community law to
which, by implication, all countries have to agree. We believe that the
European Parliament should have the nal say in the statute of the
ESCB and thus act in a real parliament any way.
In general, a central bank is not only directly accountable to a par-
liament but also to a government, which is itself accountable to the par-
liament. So it is important that a government be able to inuence its
central banks behavior. Without such instruments, accountability
cannot go beyond mere reporting by government to parliament of
central bank policies, for which government in that case cannot be held
responsible. An override mechanism for government would be an instru-
ment to change central bank policy. If the government does not inter-
fere, it apparently agrees with central bank policies and can be held
accountable for this by parliament. Such a mechanism existed in the
Netherlands before the latest change of the Dutch central bank law. It
was at one time also considered for the ECB but rejected for various
reasons. (One reason was that at the European level there is no equiv-
alent to a national minister of nance, nor is there at the European level
a full equivalent to a national parliament.)
If an override mechanism exists, it is critical that the conditions by
which it can be applied be laid down in full. The mechanism must not
be allowed to be used as a tool for undesired political inuence. The
procedure for the application for the override mechanism must be
transparent. The decision to apply the override mechanism must be
made public. Furthermore, the procedure to apply an override must
provide for a review (e.g., allow the central bank to appeal) that ensures
that the override is used judiciously.
Finally, the dismissal procedure for a central banker can account to a
mechanism of ex post accountability if a central bank ofcial can be
dismissed for bad performance, that is, for not meeting the stated objec-
tives. This is the case for the Reserve Bank of New Zealand where the
PTA between the governor of the central bank and the minister of
nance lays down the banks policy targets. Inadequate performance
can result in dismissal of the governor. In the case of the president of
the ECB, in contrast, dismissal results if he can no longer fulll the
general conditions required for his performance or if there is serious
misconduct. Presumably a mechanism like the one in New Zealand is
based on the principle of individual responsibility for monetary policy
making. Therefore this mechanism might not be appropriate since the
ECB Governing Council is collectively responsible for policymaking
(Issing 1999b).
How does the accountability of the ECB compare to that of other
central banks? De Haan et al. (1999) provide an indicator for democ-
ratic accountability based on the general denition we gave above.
13
Table 4.6 is reproduced from this study. For the 13 categories of
accountability the number of positive answers to the questions deter-
mines the score for the bank. The accountability indicator is based on
112 Chapter 4
Table 4.6
Accountability of central banks
Bank Federal
Bank of of Bank of Reserve
Various aspects of accountability Canada Japan England System ECB
1. Does the central bank law Yes Yes Yes Yes Yes
stipulate the objectives of monetary
policy?
2. Is there a clear prioritisation of No No Yes No Yes
objectives?
3. Are the objectives clearly dened? No No Yes No No (yes)
4. Are the objectives quantied (in No No Yes No No (yes)
the law or based on document based
on the law)?
Subtotal on ultimate objectives of 1 1 4 1 2 (4)
monetary policy
5. Must the central bank publish an Yes Yes Yes No (yes)
ination or monetary policy report
of some kind, in addition to
standard central bank bulletins/
report?
6. Are minutes of meetings of the No No Yes Yes No
governing board of the central bank
made public within a reasonable
time?
7. Must the central bank explain Yes Yes Yes Yes Yes
publicly to which extent it has been
able to reach its objectives?
Subtotal on transparency 2 1 3 3 1 (2)
8. Is the central bank subject to Yes Yes Yes Yes Yes
monitoring by Parliament (is there a
requirementapart from an annual
reportto report to Parliament and/
or explain policy actions in
Parliament)?
9. Has the government the right to Yes Yes Yes No No
give instructions?
10. Is there some kind of review in Yes Yes Yes Yes No
the procedure to apply the override
mechanism?
11. Has the central bank possibility No No No No No
for an appeal in case of an
instruction?
12. Can the central bank law be Yes Yes Yes Yes No
changed by a simple majority in
Parliament?
central bank laws, like most indicators for central bank independence
(see chapter 6).
As this index shows, the ECB has a low degree of (legal) democratic
accountability. Recall from our discussion above that the ECB goes in
some respects further than the law prescribes (operationalization of the
objective, monthly report, the reasoning behind specic decisions is
made public immediately, appearances before European Parliament).
Therefore the nal column of table 4.6 also provides (in parentheses)
the score for the ECB if actual practice is taken into account. While the
ECB has then a higher score, the ECB cannot be considered as the most
transparent and accountable central bank in the world (Issing 1999b,
p. 505).
4.5 Blinders Survey on Credibility
Although credibility of policy makers is widely believed to be
important, empirical evidence in support of this view is scarce. Arecent
interesting study is by Cecchetti and Krause (2002), who use the
information provided by Fry et al. (2000) to examine the extent to
which macroeconomic performance in their sample of 63 countries is
related to credibility, transparency, independence, and accountability
of central banks.
14
They nd that central bank credibility, and to a lesser
extent, transparency, is tied to ination. However, as Cechetti and
Krause constructed their index of credibility on past ination, their
results are perhaps better interpreted as suggesting that ination is
persistent.
Not only is little known about the effects of credibility, we also
know little about the determinants of credibility. According to Issing
Table 4.6
(continued)
Bank Federal
Bank of of Bank of Reserve
Various aspects of accountability Canada Japan England System ECB
13. Is past performance a ground for No No No No No
dismissal of a central bank governor?
Subtotal on nal responsibility 4 4 4 2 1
Total on accountability 7 6 11 6 4 (7)
Source: De Haan et al. (1999).
114 Chapter 4
(2001a), transparency of monetary policy can enhance credibility. By
providing the public with adequate information about its activities,
the central bank can establish a mechanism for strengthening its
credibility if its actions match its public statements (IMF 2000a). In
Jensens (2001) model increased transparency can increase the reputa-
tional costs of deviations from the ination target and therefore
increase the credibility of the central bank. However, the credibility-
enhancing effect of transparency is redundant where central bank
preferences are already public information. Chortareas et al. (2002)
argue that a high degree of transparency is desirable for central banks
with poor credibility but may be costly in terms of less exibility for
high-credibility banks.
Whether transparency enhances the credibility of policy makers is,
however, not extensively investigated in the empirical studies by
Chortareas et al. (2002) and Cecchetti and Krause (2002). The latter
authors only report that the correlation between their index of credi-
bility and their index of transparency is 0.31, while credibility is virtu-
ally unrelated with their measures of accountability and independence.
Recently some authors have presented the results of surveys among
central bankers on transparency and credibility. The comprehensive
survey by Fry et al. (2000), to which we referred above, showed 74
percent of the respondents to consider transparency a vital or very
important component of their monetary policy framework. Blinder
(2000) mailed a questionnaire to the heads of 127 central banks
soliciting their opinions on a number of issues related to central bank
credibility. The response rate was 66 percent. The respondents
were asked to answer questions relating to the importance and deter-
minants of central bank credibility. Table 4.7 summarizes Blinders
ndings.
The rst question (Q1) is: How important is credibility to a central bank?
In this case the points on the ve-point scale were as follows:
1 = unimportant
2 = of minor importance
3 = moderately important
4 = quite important
5 = of the utmost importance
The average score to the rst question is a stunning 4.83, with a stan-
dard deviation of only 0.37. Blinder (2000) asked the same question to
a smilar-sized sample of aceademic economists. The average score for
the rst question in this group is somewhat lower (4.23) while the stan-
dard deviation is higher (0.85).
The second question (Q2) is: How closely related are the concepts
of (a) a central banks credibility and (b) a central banks dedication to
price stability? In this case the ve-point scale has the following
meaning:
1 = unrelated
2 = slight related
3 = moderately related
4 = quite closely related
5 = virtually the same
Table 4.7
Blinders (2000) survey of central bankers about credibility
Standard
Question Issue Average deviation
Q1 Importance 4.83 0.37
Q2 Related to dedication to price stability 4.10 NA
Q3 Less costly disination 4.13 (2) 0.78
Q4 To keep ination low 4.39 (1) 0.60
Q5 To change tactics 4.38 (5) 0.54
Q6 To serve as lender of last resort 4.12 (6) 0.77
Q7 To defend the currency 4.29 (3) 0.70
Q8 Public servants should be truthful 4.00 (7) 0.84
Q9 For support of independence 4.34 (4) 0.75
Q10 Ranking of Q3 to Q9
Q11 Importance of CBI for credibility 4.51 (2) 0.63
Q12 Importance of transparency for credibility 4.13 (4) 0.71
Q13 Importance of history of honesty for credibility 4.58 (1) 0.52
Q14 Importance of history of ghting ination for 4.15 (3) 0.67
credibility
Q15 Importance of being constrained by a rule for 2.89 (6) 1.01
credibility
Q16 Importance of incentives (personal loss) for 2.15 (7) 1.10
credibility
Q17 Importance of small decit and low debt ratio 3.92 (5) 0.93
for credibility
Source: Blinder (2000).
Note: Ranking of Q3Q9 and Q11Q17 is shown in parentheses.
116 Chapter 4
As follows from table 4.7, the average score on this question in
Blinders survey is 4.10. The academic economists give a consid-
erably lower score (3.31). The next seven questions focus on the issue
of why credibility might be important to a central bank. Respondents
were asked to express their agreement or disagreement on a ve-point
scale, ranging from strongly disagree to strongly agree.
One argumentwith a score of 4.13 in the survey of Blinder (Q3)
is that credibility will reduce disination costs. In the ranking it even
gets the second place, also in the survey among academic economists.
Surprisingly, given this high score, the academic literature has come up
with discomforting outcomes as almost all studies report that CBI
worsens the trade-off. For instance, Posen (1998) nds a positive cor-
relation between CBI and the sacrice ratio, i.e., the cumulative
increase in unemployment that is due to the disination effort divided
by the total decrease of ination (see Eijfnger and De Haan 1996
and Berger et al. 2001 for extensive surveys of the literature on
CBI).
15
Still one might argue that what really matters for disination
costs from a theoretical point of view is credibility, which may be inu-
enced by actual (instead of legal) independence of a central bank. So
far lack of indicators for credibility have made more direct testing
impossible.
Table 4.7 also summarizes the outcomes for the other reasons given
by Blinder as to why credibility may be important. Interestingly the
argument to keep ination low receives the highest average score.
Also the argument that a credible central banker may nd it easier to
change operating proceduresas for instance, the Federal Reserve did
under Volcker in 1982receives a very high average.
Question 10 of Blinders survey lists the reasons indicated in the pre-
vious seven questions on the importance of credibility and asked the
respondents to rank them. The ranking is shown in parentheses in table
4.7. Note that there are some inconsistencies in the average scores and
the rankings. For instance, the average score for the answer that cred-
ibility will allow central banks to change tactics is 4.38, only slightly
lower than the average score for the argument that credibility will help
to keep ination low (score 4.39). However, the changing-tactics argu-
ment is only ranked fth in question 10. The argument that is it less
costly to disinate receives the fth score in terms of the average score,
while it is ranked second in question 10.
The rankings of the academic economists differs somewhat from
those of central bankers. The largest difference occurrs with respect
to the support-for-independence argument, which is ranked seventh
by the economists and fourth by the central bankers. However, the
academic economists agree with central bankers in their number
one and two rankings (i.e., to keep ination low and less costly to
disinate).
How can credibility be earned? Questions 11 to 17 in Blinders survey
give various possible answers of which the scores are again shown
in table 4.7. The top-rated method for a central bank to establish
credibility, at least according to central bankers, is to have a history
of doing what it says it will do. Although the economic literature is
full of optimal contracts for central bankers (e.g., Walsh 1995) and
incentive-compatible payment schemes (e.g., Svensson 1997), central
bankers give these options a rather low rating, as do academic
economists.
4.6 Credibility of the ECB
We were able to survey economists participating in Ifos World Economic
Survey (formerly known as Economic Survey International, ESI). The
Ifo Institute has been running this survey since 1981 (Brand et al.
1997; Haupt and Waller 2000).
16
The aim is to maintain an up-to-date
quarterly picture of the global economic situation as well as fore-
casts for the important industrialized, emerging, and developing
nations.
The veracity of the World Economic Survey (WES) results was tested
in a number of studies. The results can be summarized as follows
(Brand et al. 1997):
The survey results indicators were valuable in explaining global eco-

nomic developments.
The results were suitable for use in forecasting economic develop-

ments, although forecasting abilities are inferior to their explanatory
power.
The number of participants in the survey, which varied from country

to country, did not seem to have much impact on the quality of the
survey results.
Most of the questions that we asked were similar to those in the Blinder
(2000) survey.
17
Our rst question corresponds to Q1 in table 4.7, How
important is credibility to a central bank? Following Blinder (2000), we did
118 Chapter 4
not provide our respondents with a denition of credibility.
18
Blinder
(p. 1422) motivates this as follows: I deliberately failed to provide a
precise denition of credibility, allowing each respondent to attach his
or her own preferred meaning to the term. In fact, there appears to be
no generally agreed-upon denition.
We also did not ask our respondents to give their denition of cred-
ibility. Rather as our second question, we asked about the relationship
between credibility and dedication to price stability. This question is
almost the same as Q2 in table 4.7, How closely are the concepts of credi-
bility and dedication to price stability related?
The possible answers on a ve point-scale ranged from unrelated
(1) to virtually the same (5). Because we could only ask a small
number of questions, we did not include Blinders questions Q3 to
Q9. Instead, we asked the respondents to rank the seven reasons. Can
you rank (from 1 to 7, where 1 is highest) the following reasons that are often
considered as explanations why credibility may be important for a central
bank?
A credible central bank can reduce ination at lower social cost.
A credible central bank is better able to maintain low ination once

low ination has been achieved.
A credible central bank can more easily change tactics or operation

procedures without upsetting markets or raising concern over its
underlying objectives or resolve.
A credible central bank can more easily act as a lender of last resort
in a nancial crisis (e.g., during a market crash or bank run) without
creating fears that it has lost its dedication to ghting ination.
A credible central bank can more easily defend a countrys currency

in a speculative attack.
Central bankers are public servants that have a duty to be open and
truthful.
Credibility is important as a way to justify public support for an inde-

pendent central bank.
The outcomes of this question compare with those of question Q10 in
Blinders survey.
Next we had our respondents rank the various possibilities given by
Blinder as to how a central bank can build credibility. So Blinders ques-
tions Q11 to Q17 are combined to, Can you rank (from 1 to 7, where 1 is
highest) the following means which have been suggested to establish or create
central bank credibility?
The central bank should have a high level of independence.
The central bank should be open and transparent.
The central bank should have a history of doing what it says it will
do.
The central bank should have a history of ghting ination.
The central bank should be bound (by law or by custom) to follow a

prescribed rule that constrains decision making.
The central bank governor should take a personal loss (e.g., lower
salary or step down) if ination rises too high.
Absence of high scal decit and debt ratio create central bank
credibility.
The survey was held for the rst time in May 2000. More than 200
people lled in the questionnaire. This gave a response rate of 45
percent. The survey respondents included economists from various
countries, allowing us to differentiate between economists located in
EMU countries and those located elsewhere. We could also differenti-
ate between economists afliated with nancial institutions (banks,
insurance companies, etc.) and those working for rms or research
institutes. Last, the survey allowed us to determine whether the ina-
tion experience of the respondents country was systematically related
to the answers given.
Table 4.8 summarizes the main ndings for the rst questions of our
survey. Note that the gures for questions 3 and 4 are ranking aver-
ages and cannot be compared to the ratings of Blinders survey. As far
as the importance of credibility is concerned (Q1), our respondents
gave almost as high a mark as central bankers, although the standard
deviation is somewhat higher. Also as far as the relationship between
credibility of a central bank and its dedication to price stability is con-
cerned (Q2) the average score of our respondents is very close to those
of Blinders survey among central bankers. Professional economists
apparently agreed more on this issue with central bankers than with
academic economists.
With respect to the question of why credibility is important (Q3),
some notable differences between the two surveys show up. The
strongest divergence of rankings is on the usefulness of credibility for
120 Chapter 4
changing tactics. Our respondents give this reason for the importance
of credibility the highest ranking, whereas the central bankers in
Blinders survey placed this fth. Another interesting result is the
ranking of the importance of credibility for price stability in both
surveys. Although central bankers put this on top of their list, our
respondents ranked it third. The role of credibility in central bank inde-
pendence is only minor according to our respondents. This result is in
line with Blinders ndings for academic economists, who ranked it
seventh. However, central bankers give it rank 4.
With respect to the question as to how credibility can be built (Q4)
the rankings of our respondents are broadly in line with those of the
central bankers (and academic economists) in Blinders survey. A
history of honesty and central bank independence gets the highest
ranking in both surveys. Personal incentives for central bankers are not
regarded as adequate to earn credibility.
Table 4.8
Our survey of private sector economists about credibility
Standard
Question Issue Average deviation
Q1 Importance 4.66 0.49
Q2 Related to dedication to price stability 4.02 0.61
Q3 Less costly disination 3.31 (2) 2.09
To keep ination low 3.40 (3) 1.68
To change tactics 3.26 (1) 1.72
To serve as lender of last resort 3.74 (4) 1.71
To defend the currency 3.96 (5) 1.91
Public servants should be truthful 5.82 (7) 1.70
For support of independence 4.53 (6) 1.86
Q4 Importance of CBI for credibility 1.80 (1) 1.32
Importance of transparency for credibility 3.13 (3) 1.46
Importance of history of honesty for 2.93 (2) 1.43
credibility
Importance of history of ghting ination for 3.70 (4) 1.36
credibility
Importance of being constrained by a rule for 4.85 (5) 1.47
credibility
Importance of incentives (personal loss) for 6.38 (7) 1.07
credibility
Importance of small decit and low debt ratio 5.26 (6) 1.49
for credibility
Table 4.9 shows the outcomes of three subsamples of our respon-
dents: economists from euro-area countries, economists afliated with
a nancial institution, and economists based in countries that had rel-
atively high ination rates in the past.
19
The answers from economists
from banks and insurance companies as to the reasons why credibility
is important and how it can be built turned out to be very much in line
with the results for our total sample. The same was true for economists
located in the euro area and in countries with relatively high ination
rates in the past.
Last, we asked our respondents to rank seven central banks with
respect to their credibility, Can you rank (from 1 to 7, where 1 is highest)
the following central banks in terms of their credibility?
Table 4.9
Our survey of private sector economists about credibility: Economists from EMU coun-
tries, nancial institutions, and high-ination countries
High-
EMU Financial ination
Question Issue based Institutions countries
Q1 Importance 4.65 4.78 4.67
Q2 Related to dedication to price 4.10 4.15 4.03
stability
Q3 Less costly disination 3.29 (2) 2.82 (1) 3.43 (3)
To keep ination low 3.38 (3) 3.49 (3) 3.75 (4)
To change tactics 3.41 (1) 3.12 (2) 3.33 (1)
To serve as lender of last resort 3.62 (4) 3.81 (4) 3.85 (5)
To defend the currency 3.99 (5) 4.28 (5) 3.40 (2)
Public servants should be truthful 5.75 (7) 5.99 (7) 5.71 (7)
For support of independence 4.57 (6) 4.54 (6) 4.57 (6)
Q4 Importance of CBI for credibility 1.89 (1) 1.75 (1) 1.75 (1)
Importance of transparency for 3.05 (3) 3.09 (3) 3.36 (3)
credibility
Importance of history of honesty 3.01(2) 2.97 (2) 2.89 (2)
for credibility
Importance of history of ghting 3.71 (4) 3.59(4) 3.88 (4)
ination for credibility
Importance of being constrained 4.79 (5) 5.18 (5) 4.75 (5)
by a rule for credibility
Importance of incentives 6.43 (7) 6.19 (7) 6.36 (7)
(personal loss) for credibility
Importance of small decit and 5.11 (6) 5.35 (6) 5.05 (6)
low debt ratio for credibility
122 Chapter 4
Banca dItalia
Bank of England
Bank of Japan
Banque de France
Deutsche Bundesbank
European Central Bank
Federal Reserve
Table 4.10 presents our ndings for the credibility marks of the various
central banks. Our respondents gave the Federal Reserve the highest
mark, closely followed by the Bundesbank. The credibilities of the Bank
of England and the ECB were clearly higher than those of the Bank of
Japan and the Banca dItalia. Note that the ranking of central banks in
terms of credibility is the same as the ranking in terms of transparency
(table 4.4). One explanation may be that our respondents considered
the concepts to be closely related. Alternatively, they could have simply
ranked central banks on the basis of their recent performance.
Finally, table 4.11 shows the scores for three different groups of
respondents in our sample: economists based in an EMU country,
economists afliated with nancial institutions, and economists from a
high-ination country. Interestingly economists from EMU countries
gave the ECB a somewhat higher rating. The rating of the ECB by econ-
omists afliated with nancial institutions was a bit lower than in table
4.9, but the opposite can be seen for economists from high-ination
Table 4.10
Rankings of central banks in terms of their credibility
Central bank Average Standard deviation
Banca dItalia 6.42 (6.29) 1.02
Bank of England 3.74 (3.56) 1.19
Bank of Japan 5.48 (5.71) 1.29
Banque de France 4.86 (4.82) 1.14
Deutsche Bundesbank 1.89 (2.25) 1.12
European Central Bank 3.86 (3.52) 1.39
Federal Reserve 1.79 (1.59) 1.10
Note: The gures in parentheses in the second column show the outcome of a second
survey held in October 2001.
countries. To examine whether over time the credibility of the ECB had
improved, we repeated question 5 in another survey held in October
2001. In table 4.10 the results of this second survey are shown in paren-
theses. It is reassuring to see that the rank of the ECB had improved
somewhat.
So far we have only analyzed and compared the results of the total
samples of both surveys. However, the samples do differ signicantly
in sizethe sample of the rst survey was almost twice as big as in the
follow-up surveyand in composition. Some participants took part in
the rst survey but not in the second, and vice versa. The answers of
experts who participated in both surveys allowed for a more in-depth
analysis of the change of assessments and opinions over time. Unfor-
tunately, this reduced the sample to 58 participants. It turned out that
the results for this group were identical to those of the full sample (not
shown). Respondents in EMU countries gave the ECB a higher rating
in the follow-up survey. Although they generally considered the ECB
a bit less credible than most other respondents, among respondents
from nancial institutions the ECB gained ground and surpassed the
Banque de France.
4.7 Conclusions
We distinguished among ve aspects of openness of central banks:
political, economic, procedural, policy, and operational disclosure.
From the review of the theoretical literature on central bank disclosure
and transparency we found no consensus over the desirability, from an
Table 4.11
Rankings of credibility of central banks: Economists from EMU countries, nancial insti-
tutions, and high-ination countries
Financial High-ination
Central bank EMU based Institutions countries
Banca dItalia 6.30 6.24 6.23
Bank of England 3.95 3.71 3.65
Bank of Japan 5.53 5.80 5.68
Banque de France 4.83 4.76 4.90
Deutsche Bundesbank 2.03 1.94 1.94
European Central Bank 3.56 4.03 3.70
Federal Reserve 1.81 1.50 1.90
124 Chapter 4
economic point of view, of the various categories of disclosure and
transparency. Clearly, more study needs to be done on the economic
consequences of disclosure and transparency.
According to the Eijfnger-Geraats index of disclosure, the ECB has
a relatively good overall rating due to its good scores for political and
economic disclosure. The ECB also has a high rating in terms of most
other indicators for central bank disclosure. This contrasts with the
ndings of various surveys among private sector economists, includ-
ing our own, in which the ECBs operations were perceived to be
opaque. Our indicator for accountability suggests that the ECB does
not rank high, although the ECB goes further than required by law in
providing information. As to perceived credibility, the respondents in
our survey did not give the ECB a high rating. Still our results suggest
that over time the credibility of the ECB has increased somewhat. The
views of our respondents as to how important credibility is for mone-
tary policy making and its determinants are broadly in line with those
of central bankers.
5.1 Introduction
As we pointed out in chapter 1, within the Eurosystem the national
central banks play an important role. Unlike other similar central
banks, the ECB is very decentralized. This is not only true for the imple-
mentation of monetary policy (as discussed in chapter 2) but also for
the decision-making process within the Governing Council of the ECB.
In this chapter we consider rst, in section 5.2, the decentralized
nature of the Eurosystem. In section 5.3 we show how this decentral-
ized setup can be problematic. A crucial factor is the extent to which
the countries in the euro area are alike. Where countries (or sizable
regions) are at different points in the business cycle or have diverging
ination rates, decision-making on the appropriate monetary policy
stance becomes a difcult task. Furthermore, if the monetary policy
transmission mechanism differs across the member countries of the
monetary union, the appropriate size and timing of monetary policy
decisions become difcult to assess. Various authors have argued that
monetary policy transmission differs substantially among countries in
the European monetary union because of differences in nancial struc-
tures. In sections 5.4 to 5.6 we turn to analyze synchronization of the
business cycles of the countries in the euro area, their diverging ina-
tion rates, and the differences in monetary transmission across EMU
countries. In section 5.7 we present our conclusions.
5.2 The Decentralized Eurosystem
Regional central banks have a very strong voice in the decision making
of the Eurosystem. Table 5.1 compares the ECB with the German and
American central banks in terms of the power of the regional central
5
Centralization or
Decentralization
126 Chapter 5
banks. It follows that the decision-making structure of the ECB is less
centralized than that of comparable central banks. In terms of voting
power, the position of the Executive Board within the Eurosystem is
therefore relatively weak. Bini Smaghi and Gros (2000) argue that its
powers are also limited in some other respects. First, the Board has the
responsibility to set up meetings of the ECB Governing Council, but it
does not have an exclusive power of initiative. Second, several com-
mittees have been created in all major areas of ECB competence to assist
in the work of the Eurosystem. These committees are mandated by the
Governing Council and alsogenerally via the Executive Board
report to the Council. Third, the Executive Board has no budgetary
autonomy, since the Governing Council has to approve the budget.
Finally, the ECB has no control over the many activities performed by
national central banks. They are free to perform certain functions,
unless the Governing Council decides by two-third majority that these
activities interfere with the objectives and tasks of the Eurosystem.
The ECB also differs considerably from the Federal Reserve and the
Bundesbank in terms of economic size. Table 5.2 shows the distribu-
tion of the share in total GDP of the member central banks of the
Bundesbank, the Federal Reserve, and the Eurosystem. Note that in
the United States the regional central banks are close in size, whereas
in the euro area the economic sizes are uneven. Germany is in-between:
the central banks of NordrheinWestfalen (22 percent) and Bavaria (17
percent) have substantially more economic power than most of the
other banks.
As a consequence of the institutional setup of the Governing Council,
political power and country size diverge. As shown in gure 5.1, for
seven out of the current twelve countries in the monetary union the
Table 5.1
Distribution of voting power: Center versus regions
Bank Center Regions Center/region
Bundesbank before 1957 1 9 0.11
Federal Reserve System 7 5 1.40
ECB 1999 6 11 0.55
ECB 2001 6 12 0.50
Source: Berger et al. (2004).
Centralization or Decentralization 127
Table 5.2
Share in total GDP of central banks (distribution), 1999
Share in GDP (%) Germany
a
United States EMU
05 0 1 7
510 5 10 2
1015 2 0 0
1520 1 1 1
2030 1 0 1
>30 0 0 1
Total 9 12 12
Source: Berger and De Haan (2002).
a. Germany: 1998.
0 5 10 15 20 25 30
35
GER
FRA
ITA
ESP
NLD
BEL
AUS
FIN
GRC
PRT
IRL
LUX
Share (%)
Economic weight (EW)
Political weight (PW)
1 Council seat
Figure 5.1
Economic and political weights of central banks in the current euro area. (Source: Berger
et al. 2004)
128 Chapter 5
political weight (i.e., 1/18 or about 6 percent of all votes in the Gov-
erning Council) exceeds economic weight (i.e., their share of the euro
area GDP).
Another important difference with the Bundesbank and the Fed is
that the staff employed by the ECB is much smaller than that of the
central banks of its system (see table 5.3). In time this imbalance may
be corrected.
1
As Bini Smaghi and Gros (2000) point out, any proposal
by the Executive Board of the ECB to increase staff has to be approved
by the Governing Council. An opposite situation exists in the United
States, where the Board of Governors responsibility is to approve the
budgets of district banks.
Besides staff size, there is the relevance of staff qualications. This
has many dimensions, an important one being the staffs research activ-
ities. As sidebar 10 shows, based on publications in international jour-
nals relative to the size of the staff involved in research, the position of
the ECB is surprisingly strong.
Table 5.3
Staff: Total size and size of the research departments, 19901999
Averages
Central Bank of Total staff Research staff Ratio
Austria 1,243 50 0.041
Belgium 2,695 49 0.018
Denmark 582 33 0.057
Finland 826 45 0.055
France NA NA NA
Germany 2,761 69 0.025
Greece 3,240 118 0.038
Ireland 621 23 0.037
Italy 9,229 212 0.023
Luxembourg 141 22 0.156
Netherlands 1,655 95 0.057
Portugal 1,966 129 0.067
Spain 3,175 253 0.080
Sweden 807 42 0.056
United Kingdom 4,050 116 0.031
ECB 633 110 0.172
Source: Eijfnger et al. (2002).
Notes: Data for Luxembourg and the ECB refer to 199899; data for Sweden refer to
199298. For Portugal the data until 1996 include statistics staff.
10 Research Output of European Central Banks
From the perspective of a regional central bank in a decentralized sys-
tem of central banks quality of research is important (Goodfriend 1999;
Angeloni 1999). The diversication of research within a system of central
banks brings a variety of analytical perspectives to policy deliberations
that are invaluable in an increasingly complex economy. Moreover a
system of regional banks harnesses competitive forces to encourage inno-
vative thinking within the central bank.
Eijfnger et al. (2002) surveyed the research output of the European
central banks for the period 1990 to 1999. The questionnaire pinpointed
the following concerns:
Total staff. How many employees were working at your central bank
during the last ten years?
Research staff size. How many employees were working at the eco-
nomic and research departments, measured over the same period?
Publication record. How many scientic journal articles have been

published by the staff of your economic and research departments in
international, refereed journals and when were these articles published?
Eijfnger et al. (2002) measure quality by counting the number of journal
publications per employee in the research and economics departments.
Measuring output for each employee seems natural because the various
central banks differ a lot in size. As considerable quality differences exist
between scientic journals, they apply a weighting scheme. All interna-
tional journals in which central bank employees had published have
been ranked into three classes: top journals, very good journals, and good
journals. Atop publication delivers three points, a very good publication
two points and a good publication one point. Eijfnger et al. have cal-
culated the research output per employee by multiplying the number of
journal articles with the respective scores for the journal (3, 2, or 1) and
dividing the resulting sum by the number of employees. Table 5.4 shows
the results.
The table shows that the ECB is in sixth place. However, if the output
over the period 1994 to 1999 is also taken into account, the ECB occupies
the fourth place, before the central banks of Austria and Portugal. This
is a remarkable achievement, given the relatively short period for
which data are available. In a more recent assessment of ECB research,
Goodfriend et al. (2004, p. 46) similarly conclude that Our overall assess-
ment of ECB research is quite positive. In the short time since its creation,
the ECB has managed to build up signicant research capabilities, not
only in DG Research but also in other business areas. This shows in the
hiring of PhD economists, the production of a large number of working
papers, the publication of research in leading journals, and the partici-
pation of ECB staff in many academic conferences and workshops.
130 Chapter 5
Table 5.4
Weighted journal publications per employee of European central banks (including the
ECB), 19901999
Total number Quality-weighted
of journal Quality-weighted number of articles per
Central Bank of publications number of articles employee in research
Austria 14 17 0.34
Belgium 7 9 0.19
Denmark 3 5 0.15
Finland 20 35 0.78
France NA NA NA
Germany NA NA NA
Greece NA NA NA
Ireland 3 4 0.17
Italy 89 137 0.64
Luxembourg NA NA NA
Netherlands 49 68 0.72
Portugal 31 50 0.39
Spain 29 51 0.20
Sweden 5 12 0.24
United Kingdom 8 14 0.08
ECB (199499) 29 50 0.45
ECB (199899) 13 23 0.21
Notes: Figures for the United Kingdom and Sweden refer to 199899. Figures for the
ECB refer to 199499 or 199899. In the rst case the publications of the ECB research
staff during 199497 were also counted. Information for the United Kingdom is incom-
plete, while data for Italy were made available after the publication of Eijfnger et al.
(2002).
5.3 Risks of Decentralization
If the Executive Board of the ECB is in a relatively weak position vis-
-vis the national central banks in the Eurosystem, what will be the
consequences of this institutional setup? Various critics of EMU have
raised concerns that a common monetary policy can be undermined by
diverging economic developments in the countries in the eurozone.
2
Indeed, the severity of the depression of the 1930s has been attrib-
uted to serious policy mistakes by the Federal Reserve, caused by its
excessively decentralized decision-making structure, by Friedman and
Schwartz (1963, pp. 41516) in their seminal study of American mone-
tary policy:
There is more than a little element of truth in the jocular description of a com-
mittee as a group of people, no one of whom knows what should be done, who
jointly decide that nothing can be done. And this is especially likely to be true
of a group like the Open Market Policy Conference, consisting of independent
persons from widely separated cities, who share none of that common outlook
on detailed problems or responsibilities which evolves in the course of long-
time daily collaboration.
In Friedman and Schwartzs view, the consequence of a weak center is
that the decision-making process becomes too cumbersome and slow,
possibly resulting in suboptimal decisions. The risk of suboptimal deci-
sions in the euro area is especially large if national central bank gov-
ernors give priority to national objectives, as they did before EMU. If,
for instance, ination in Germany and Francethus most of the euro
areais in line with the objective of price stability while in the small
countries ination is increasing, will the governors of the central banks
of the latter countries favor a reduction in interest rates?
One could conjecture at this stage that the primary objective of the
ECB, (i.e., price stability in the euro area) and the independence of the
central banks within the Eurosystem should go against this risk. Still
economic differences across countries may affect the voting behavior
of national central bank governors within the ESCB. This is supported
by the experiences of the Federal Open Market Committee (FOMC) of
the US Federal Reserve where the voting is inuenced by the economic
situation in the various Federal Reserve Districts (Meade and Sheets
2002). Likewise Berger and De Haan (2002) have analyzed data on indi-
vidual voting behavior in the decision-making body of the Bundesbank
on discount rate changes in the period 1948 to 1961.
3
They nd that dif-
ferences in economic performance translated into different views by the
various state central banks on how monetary policy was to be con-
ducted. The probability of a representative not to vote yes on a policy
change is signicantly larger, the larger are the differences between
regional and average ination. The same holds for growth differentials,
though at a lower level of signicance.
The studies of Meade and Sheets (2002) for the United States and
of Berger and De Haan (2002) for Germany therefore concur in their
ndings that economic differences across regions have affected voting
behavior in the decision-making bodies of the central banks concerned.
Can we be certain that the ECB will behave differently? Or should we
worry that ECB decisions might lack the truly European perspective
envisioned by the Maastricht treaty?
4
And what will happen after the
132 Chapter 5
upcoming enlargement of the monetary union? Sidebar 11 summarizes
a model developed by Berger (2002), suggesting that different eco-
nomic developments may lead to suboptimal policies by the ECB.
We illustrate the same point in a very simple way in table 5.5. In the
table we show the GDP-weighted and the nonweighted ination and
output growth in the euro area for 2000 and 2001. Price stability in the
euro area indicates that the ECB should try to keep weighted ination
below 2 percent in the medium run. If, however, national central bank
governors focus on national ination, the nonweighted ination gure
becomes more relevant. It follows from table 5.5 that there are sub-
stantial differences between the weighted and nonweighted ination
and growth gures. If national central bank governors take national
interests into account, they will decide differently than when they focus
on the euro area as a whole.
Whether economic differences may lead to differences of opinion
within the Eurosystem on the proper monetary policy stance depends,
of course, crucially on the extent to which differences in business cycles,
ination, and monetary transmission in EMU exist and whether they
will remain. We will examine these issues in the next sections.
Say, for the moment, that ination and business cycles are very
similar, could there still be conicts in the ECB Governing Council due
to differences in preferences? Again, the experience of the Bundesbank
can shed some light on this issue. Berger and Woitek (1999) show that
dissent voting in the early Bundesbank Council was also correlated
with political preferences. Following Vaubel (1997), they categorize
Council members according to the political background of their nom-
inating state or federal government.
5
They report that left-wing Council
members, meaning those members that were nominated by social-
democratic governments, were signicantly inclined to resist (or not to
support) interest rate increases. Moreover Berger and Woitek (1999)
nd a systematic inuence of the degree of conservatism in the
Bundesbank Council on German monetary policy 1950 to 1994. As a
rule more conservative Bundesbank Councils (i.e., Councils with a
majority of members appointed by conservative governments) take a
more active stance in their reaction to shocks. So the German expe-
rience suggests that not only divergence in regional economic devel-
opment but also differences in political preferences seem to inuence
actual central bank behavior.
Following Berger and Woitek, we list in table 5.6 the presidents
of the various national central banks in the euro area in 2001, their
11 A Model of ECB Decision Making
Berger (2002) develops a simple Barro-Gordon type model of monetary
policy making within an enlarged euro area that illustrates the potential
danger of diverging economic developments within the union. Output
in the in and out regions after euro area enlargement develops
according to a Lucas supply function:
(1)
where y measures output, p (headline) ination, p
e
(headline) ination
expectations, and e is a regional output shock with zero mean and known
variance. Natural output is normalized to 0. The headline ination is the
sum of ination in the tradable-goods sector, , assumed to be under
direct and full control of the ECB, and a region-specic structural (exoge-
nous) component, D
p
:
(2)
The simplest possible representation of decision making within the
ECB Governing Council is a bargaining approach that abstracts from pos-
sible strategic interaction among Council members. Along this line the
ECB Governing Council sets a tradable-goods ination in the euro area
by weighing the preferred policies of the Board and the national central
bank governors:
(3)
with b [0, 1] measuring the political weight or, to be precise, the overall
vote share of Executive Board members in the Council and
Board
and
NB
representing the Boards and the governors preferred tradable-
goods ination rate, respectively. Since the vote shares of the in and
out region can differ, the preferred policy of the national central bank
governors is equivalently described as
(4)
where g [0, 1] measures the relative voting power of the in region.
Thus the overall vote share or bargaining power, with which the inter-
ests of all parties involved enter into the ECB decision-making process,
is as follows: for the in region (1 - b)g, for the out region (1 - b)(1 -
g ), and for the Board b.
The in regions central banks ideal monetary policy is assumed to
proceed from a standard quadratic loss function that increases in the
deviations of the regions headline ination and output from targets set
to 0:
(5)
The relative weight of the real target is l > 0. It is assumed that the out
regions central bank takes a more ambitious output target, y*
out
> 0, while
L y
in in in
= + p l
2 2
.

, p gp g p
NB in out
= + -
( )
1
p

, p p p
ECB Board NB
= + -
( )
b b 1
p p
p i i
in, out. = + =
,
,
D i
p
y i
i i
e
i
in, out, = - + = p p e ,
134 Chapter 5
the weight associated with output losses, l, as well as its ination target
is the same as in the in region:
(6)
From equations (1), (2), (5), and (6), it is straightforward to derive the
preferred policies of both regions. As Berger (2002) shows, the preferred
policy of the out region differs from that of the in region in two
respects. First, the more ambitious output target implies a higher rate of
ination. Second, to compensate for the presence of structural ination,
the out regions central bank aims for lower tradable-goods ination.
The Executive Board can be assumed to choose a monetary policy that
minimizes the loss function based on economically weighted euro area
averages of the headline ination and output, in line with the policy
targets specied in the Maastricht treaty:
(7)
where c [0, 1] is the economic weight (e.g., the share in aggregate euro
area GDP of the in region). From equations (1) and (2), it is easy to
show that this implies that the higher the ination in the out region is
and the higher the regions impact on euro area ination, the lower the
Board will set tradable-goods ination to compensate the impact of struc-
tural ination in the out region on the overall euro area ination rate.
Berger (2002) shows that under this setup, and assuming rational
expectations, equilibrium ination in the euro area will be
(8)
The rst part on the right-hand side reects the Boards intention to com-
pensate for the out regions structural ination by lowering tradable-
goods ination, weighted by b, which is the Boards vote share in the
ECB Council. The second element in (8) summarizes the conicting
policy objectives of the out region itself. On the one hand, the regions
central bank also aims at decreasing tradable-goods ination to com-
pensate for its higher structural ination rate (-D
p,out
); on the other, the
presence of a more ambitious growth target gives rise to an inationary
bias (ly*
out
). The net effect of these competing forces on equilibrium ina-
tion depends on the ambitiousness of the out regions growth target,
the importance of the output target in its loss function, and the size of
its structural ination problem. Finally, the third element on the right-
hand side of equation (8) shows that the ECB will shift tradable-goods
ination in the euro area to counter regional output shocks. The weight
allocated to either regions output shock is the sum of the weights
attached to output stabilization in the relevant region by the respective
central bank (i.e., (1 - b)(1 - g) for the out and (1 - b)g for the in
*
.
, ,
p c g l
l
l
c g e c g e
p p ECB out out out
out
= - -
( )
+ -
( )
-
( )
- ( )
-
+
+ -
( ) [ ] + -
( )
+ -
( )
-
( ) [ ] { }
b b y
b b b b
in
1 1 1
1
1 1 1 1
D D
L y y
Board in out in out
= + -
( ) [ ] + + -
( ) [ ] cp c p l c c 1 1
2 2
,
L y y
out out out out
= + - ( ) p l
2 2
* .
region) and the Board (i.e., b
c
in case of the in and b(1 - c) in case of
the out region).
How does actual monetary policy in the euro area as described in
equation (8) deviate from a benchmark policy that would be imple-
mented if all Governing Council members were solely interested in
targets specied by the Maastricht treaty? A reasonable benchmark
policy rule along this line is one that stabilizes economically weighted
euro area averages of output and ination around zero. The idea is to
keep, on average, prices stable and output at its natural level:
(9)
In words, * is the rate of tradables ination that minimizes the loss func-
tion L* subject to equations (1) and (2). If monetary policy were con-
ducted in line with this rule, introducing rational expectations would
yield equilibrium tradables ination of
(10)
A comparison of the benchmark euro area policy with actual ECB
policy as depicted by equation (8) reveals a number of crucial differences:
Average tradables ination as described by equation (8) will, in general,

deviate from the benchmark (10). This is always true as long as ly*
out

D
p,out
. In particular, ination is likely to exceed the ination rate achieved
under the benchmark policy if the inationary bias introduced by the
out regions central bank is high relative to the regions structural ina-
tion problem, meaning ly*
out
> D
p,out
. Moreover ination in the euro area
will be the higher, the higher is the political weight of the out region
in the ECB Council.
Actual stabilization policy will, as a rule, not be optimal. In particular, it

is straightforward to show that if the out regions political weight in
actual ECB decision making deviates from its economic weight and
output shocks in the in and out region do not coincide, the ECBs
stabilization efforts will deviate from the rst-best benchmark.
Decreasing the mismatch between economic and political weights can
bring actual stabilization policy closer to the benchmark and, if the out
region was politically overrepresented before, reduce actual ination.
* .
,
p c
l
l
ce c e
p
= - -
( )
-
+
+ -
( ) ( )
1
1
1 D
out in out
* * p cp c p l c c = + -
( ) [ ] + + -
( ) [ ]
( ) ( )
arg min
s.t. 1 and 2 .
in out in out
L y y 1 1
2 2
136 Chapter 5
Table 5.5
Weighted and nonweighted ination and output growth in the euro area, 2000 and 2001
Ination Ination Output Output
Country in 2000 in 2001 growth in 2000 growth in 2001
Austria 2.0 2.3 3.0 1.0
Belgium 2.7 2.4 4.0 1.0
Finland 3.0 2.7 5.6 0.7
France 1.8 1.8 3.8 1.8
Germany 2.1 2.4 3.0 0.6
Greece (2.9) 3.7 (4.1) 4.1
Ireland 5.3 4.0 11.5 5.9
Luxembourg 3.8 2.4 7.5 3.5
Italy 2.6 2.3 2.9 1.8
Netherlands 2.3 5.1 3.3 1.3
Portugal 2.8 4.4 3.5 1.7
Spain 3.5 2.8 4.1 2.8
Nonweighted average 2.9 3.0 4.7 2.2
GDP weighted average 2.3 2.5 3.5 1.5
Source: Own calculations based on data from De Nederlandsche Bank.
Table 5.6
Governors of national central banks and their political backgrounds, 2001
Political Government responsible
Country Governor background for appointment
Austria K. Liebscher C S + C
Belgium G. Quaden S L + S +
Finland M. Vanhala C S + C + L
France J.-C. Trichet C C
Germany E. Welteke S S +
Greece L. D. Papademos S S
Ireland M. OConnell ? L
Italy A. Fazio C S + C
Luxembourg Y. Mersch C C + L
Netherlands N. Wellink C S + L
Portugal V. M. Ribeiro Constncio S S
Spain V. Caruana C C
Source: Berger and De Haan (2002).
Note: S: socialist or social democratic; C: conservative or Christian democratic; L: liberal;
+ other parties than S, C, or L.
political background, and the political color of the government that
appointed the governor. Although the indicator is very crude, it sug-
gests that there are differences in the degree of conservativeness
appearing in the euro area.
6
Adebatable question is whether these dif-
ferences in preferences are in decline, meaning whether there is con-
vergence in preferences.
5.4 Diverging Business Cycles in the Euro Area?
In the previous section we noted that differences in the business cycle
in the various EMU countries could affect the voting behavior of
national central bank governors in the Governing Council of the ECB.
7
Business cycles can differ across countries for various reasons. First,
countries experience different shocks. Second, they respond differently
to common shocks. This may be caused by differences in the reaction
of policy makers to a common shock or because of differences in the
national or regional composition of output (Wynne and Koo 2000). Also
differences in nancial structure may lead to differences in the mone-
tary policy transmission mechanism (see section 5.6). Various studies
have pointed out that business cycles in the euro area diverged con-
siderably in the past (e.g., see Christodoulakis et al. 1995).
However, no matter how important divergent business cycles were
in the past, in assessing dangers for suboptimal monetary policy
making by the ECB, the crucial question is how likely it is that busi-
ness cycles will diverge in the future. Two views have been put forward
on this issue. According to a study by the European Commission
(Emerson et al. 1992) further economic and monetary integration will
lead to less divergence. For one thing, economic policies in the euro
area will be more similar. As Lamfalussy (1997)the rst president of
the European Monetary Institute, the predecessor of the ECBputs it:
With the emergence of a . . . stability culture in the conduct of monetary and
scal policies, the risk of asymmetric policy reactions during the coming years
would appear to me to be much smaller than any time since the end of the last
war.
Krugman (1991), on the other hand, has argued that trade integration
does lead to regional concentration of industrial activities. In Europe a
similar concentration of industries can be expected to take place as in
the United States (e.g., Silicon Valley), mainly because of economies of
scale and scope. In such a concentration process, sector-specic shocks
138 Chapter 5
can become region-specic shocks, thereby increasing the likelihood of
asymmetric shocks and diverging business cycles.
8
In the ongoing debate over business cycle synchronization in the
euro area, two related issues are being discussed. The rst is whether
business cycles in the euro area have become more similar. The second
is what factors drive business cycle synchronization.
9
On the rst issue, the literature has not yet reached a consensus
whether business cycles of the countries in the euro area have con-
verged.
10
In table 5.7 we illustrate this in summarizing the main aspects
of some representative studies. The differences between the various
studies are explained in part by the use of different data. Other reasons,
however, include the use of different methods of identifying business
cycles and assessing convergence. As pointed out by Massman and
Mitchel (2003), competing methods for the computation of a business
cycle have been suggested. One prominent view is that an economic
time series can be decomposed into the sum of trend and cyclical
components, although there remains disagreement over how the trend
should be identied and estimated. An alternative view rejects the
concept of trend-cycle decomposition and denes a business cycle in
terms of the turning points in the original data series, hence not relying
on the estimation and extraction of a trend series. There is also no con-
sensus on how convergence between business cycles should be gauged.
Suggestions include looking for increased bivariate correlation of cycli-
cal components, for decreased cyclical disparity, or for evidence of an
emerging common factor that drives individual countries business
cycles.
As to the second issue, the various factors considered to affect busi-
ness cycle synchronization include trade relations (Frankel and Rose
1998), specialization (Imbs 2004a), monetary integration (Fats 1997),
nancial relations (Imbs 2004a), and the presence of borders (Clark and
van Wincoop 2001).
A good illustration of the debate on the degree of business cycle syn-
chronization in the euro area is the controversy between Artis and Zhang
(1997, 1999), who conclude that European business cycles have become
more synchronized, and Inklaar and De Haan (2001), who nd that
cycles are better correlated (against Germany) in the period 1971 to
1979 than in the period 1979 to 1987. They argue that this is inconsis-
tent with Artis and Zhangs (1999) view that increased monetary inte-
gration, specically after the creation of the ERM in 1979, and business
cycle synchronization are positively related. According to Artis and
Table 5.7
Studies on business cycle synchronization in the euro area
Measure of Convergence
Study Data used cycle measure Conclusions
Artis and OECD monthly PAT, HP, Lead and lag Cycles have
Zhang data of linear bivariate become more
(1997, 1999) industrial trend; two correlation with groupspecic after
production subsamples Germany and ERM, correlations
(pre- and United States not different acoss
post-ERM) lters after ERM
Inklaar and Ibid. HP, two Ibid. Mixed outcomes,
De Haan subsamples no replication of
(2001) (pre- and results of Artis and
post-ERM) Zhang (1999)
Wynne and Penn World Baxter-King Pairwise Null of no
Koo (2000) Tables of GDP, correlations, correlation
annual data using GMM between EU
founding members
rejected, but lower
correlation with
more recent
members
Dpke OECD data of HP, linear, Rolling Correlations
(1999) Big 5 euro area segmented contemporaneous among most
countries trend correlations based countries and the
on 5-year moving euro area increases
average of each but that of
country with Belgium falls
euro area
Agresti and ECB euro area Baxter-King Contemporaneous Each country
Mojon wide model and lagged cross- highly correlated
(2001) (AWM) data of correlation between with euro area as
GDP and GDP each country and whole, with lowest
components for the euro area values for
10 countries periphery
Harding and ECB AWM data Harding- Correlation and Relatively low
Pagan (2001) of GDP for Pagan rule regression methods correlations among
euro area, on level on binary series member countries
OECD data for series and and euro area
United States detrended
(linear, HP,
PAT) series
Massmann OECD Various Pairwise Properties of the
and Mitchel monthly data methods correlation business cycle
(2003) of industrial coefcients using depend on how
production, a method of the business cycle
1960:12000:8 moments is measured. Euro
estimator; the area has often
entire alternated periods
Zhang, the ERM forced countries to follow similar monetary policies
and has thereby reduced the possibility of following independent mon-
etary policies. The latter are often regarded as a major source of asym-
metric (demand) shocks. Not surprisingly, European monetary policy
makers welcomed results suggesting that business cycles have become
more similar in the euro area. For instance, Trichet (2001, pp. 56) states
that
. . . we can be reasonably condent in the increasing integration of European
countries, and in the fact that economic developments are becoming more and
more correlated in the area. This has been highlighted, in the academic eld,
by several empirical investigations: I would mention authors like Artis and
Zhang (1999) who found evidence that business cycles are becoming more
synchronous across Europe.
140 Chapter 5
Table 5.7
(continued)
Measure of Convergence
Study Data used cycle measure Conclusions
distribution of all of convergence
correlation and divergence
coefcients is in the last 40 years
analyzed, using
rolling windows
Artis (2003) IMF Quarterly Band-pass Stylized facts Not much
GDP data for ltered analysis and evidence of a
22 countries, series cross-correlations European cycle
including ten
countries in
the euro area
Darvas and OECDs Hodrick- Cycle correlation Rather strong
Szapry Quarterly Prescott with euro area, comovement with
(2004) National and band- leads/lags, the euro area for
Accounts GDP pass lter volatility, most EMU
and persistence of members; more
components the cycle, and a synchronization
for 10 euro measure of over time
area countries; impulse response according to all
quarterly data the correlation
between 1983 measures
and 2002 calculated,
grouped in four particularly since
nonoverlapping 1993
5-year
periods
Source: Update of table provided by Massmann and Mitchel (2003).
Massman and Mitchel (2003) re-consider the evidence that sparked
this controversy between Artis and Zhang and Inklaar and De Haan,
using forty years of monthly industrial production data to examine the
relationships among the business cycles of the 12 countries in the euro
area, employing eight different measures for the business cycle. They
compute pairwise correlation coefcients for the 12 countries business
cycles using a method of moments estimator that also yields an asso-
ciated measure of uncertainty. To examine the evolution of this estimate
over time, Massman and Mitchel use a series of rolling windows, rather
than windows of xed width. Their measure of convergence of busi-
ness cycles exhibits common features across the alternative measures
of the business cycle. Interestingly Massman and Mitchel nd that there
have been periods of convergence and periods of divergence. The esti-
mated mean correlation coefcient for the 12 European business cycles
is on average positive and signicant, but there has been considerable
volatility. The correlation was trending upward until the mid 1970s and
reaching peaks of around 0.8, for most measures of the business cycle.
Then correlation, in general, falls to zero in the mid to late 1980s and
is statistically insignicant, lending support to Inklaar and De Haans
(2001) nding that correlations of euro area countries with Germany
were higher in 1971 to 1979 than in 1979 to 1987. Correlation then rose
in the late 1980s to values in the range 0.6 to 0.8, before slumping quite
rapidly in the early 1990s. Since then correlation between the euro area
countries has risen but remained volatile; during the mid 1990s corre-
lation even appeared to have declined. The estimates for the most
recent period indicate that the correlation for the 12 European cycles
has risen from the trough in the early 1990s.
Also Darvas and Szapry (2004) nd evidence in support of more
business cycle synchronization in the euro area since the run-up period
to EMU. These authors draw on GDP data and also on the extent of
synchronization in the major expenditure and sectoral components
of GDP. Their results suggest that Austria, Belgium, France,
Germany, Italy, and the Netherlands show a high degree of synchro-
nization by all measures used. This result applies not only for GDP but
also for its components. The synchronization signicantly increased
between 1993 to 1997 and 1998 to 2002.
11
Portugal, Finland, and
Ireland show the lowest correlation with the euro area cycle, particu-
larly for consumption and services. It should, however, be pointed
out that when correlations are calculated with the euro area, an
upward bias is created, since all countries are, by denition, included
142 Chapter 5
in the euro area aggregate. This bias may be substantial for the bigger
countries.
An alternative approach to assess business cycle similarities is to
examine to what extent there is evidence of an emerging common
factor that drives individual countries business cycles. Artis (2003, p.
2) is a recent example of this approach. In his study he comes to less
optimistic conclusions than in his previous work with Zhang: the
European business cycle is a more elusive phenomenon than we
might have expected; whilst some European countries seem to stick
together, there are many which do not. In any case, the US and Japan
are often to be found as closely associated with those European coun-
tries that do stick together as with others. In line with the conclusions
of Massman and Mitchel (2003), Artis nds that there is no coherent
movement toward an exclusively European cycle.
Artis et al. (2002) also nd no systematic convergence or divergence
tendencies in the classical business cycle (where turning points are
identied on the basis of an absolute decline, or rise, in the value of
GDP). The level of dispersion of the member countries growth rates
peaked in the 1970s, declined until 1985, and creeped up in 1990 to 1995
and again in 1999 to 2000. Dispersion was relatively small during the
periods 1985 to 1990 and 1995 to 1998. The volatility of growth in the
last 15 years has been lower than in the period 1970 to 1985. When Artis
et al. (2002) use the deviation cycle (whose turning points are dened
as points where deviations occur in the rate of growth of GDP from an
appropriately dened trend rate of growth), they nd stronger evi-
dence in favor of convergence, since there is a systematic tendency for
cross-sectional dispersion to decrease over time.
Artis et al. (1999) use univariate Markov switching autoregressions
(MS-AR) for individual countries to detect changes in the mean growth
rate of industrial production and a Markow switching vector autore-
gression model (MS-VAR) to identify a common cycle in Europe. They
see evidence of a common unobserved component governing the busi-
ness cycle dynamics in Europe, such as might suggest the existence of
a common business cycle. Similarly Forni and Reichlin (2001) show that
the business cycle of European regions can be decomposed into a Euro-
pean component, a national component, and a regional component,
with the European component having a larger role than the national
components. The share of the European regions GDP variance that is
explained by the common European business cycle ranges between 40
and 60 percent for most countries of the euro area (Portugal and Greece
being the exception) while the share of the national components ranges
between 20 and 35 percent. The rest of the variance is driven by the
regions idiosyncratic components.
12
Last, Kaufman (2003) uses time series on industrial production
growth of individual countries to investigate whether there is a
common growth cycle for the euro area countries and whether the syn-
chronization has changed over time. She uses an autoregressive panel
data framework and Bayesian simulation methods. Her results support
the idea of increasing synchronization among the euro area countries
due to the integration process.
One of the factors that may affect business cycle synchronization is trade
intensity. Theoretically trade intensity has an ambiguous effect on syn-
chronization. Standard trade theory predicts that openness to trade
leads to increased specialization in production and interindustry
patterns of international trade. If business cycles are dominated by
industry-specic shocks, higher trade integration, by bringing about
more specialization, can lead to decreasing business cycle correlations.
Furthermore the higher integration in both international nancial
markets and goods markets cushions any asymmetric shocks to
contries because of the diversication of ownership and specialized
production structures (Kalemli-Ozcan et al. 2003). On the other hand,
if business is dominated by intra-industry trade, deeper trade links will
not necessarily result in deeper specialization along industry lines. In
that case industry-specic shocks can lead to more symmetric business
cycles. Intensive trade relations between countries may also lead to the
export or import of a business cycle caused by demand uctuations, as
changes in income in one country will normally also lead to a changed
demand for foreign goods.
Despite this theoretical ambiguity, starting with Frankel and Rose
(1998), many studies have found support that trade intensity will, in
general, enhance business cycle synchronization. Most studies exam-
ining this issue nd a positive association in the trade between coun-
tries and their business cycle synchronization, regardless of the way in
which the trade relationship is modeled. However, more recent studies
tend to nd somewhat lower effects than those reported by Frankel and
Rose (1998). For instance, Gruben et al. (2002), using the same group
of 21 countries as Frankel and Rose, conrm their general conclusion,
that increased trade leads to increased business cycle correlation, but
144 Chapter 5
nd the trade effect on business cycle correlation to be about half
the Frankel and Rose point estimate (see section 6.3.1 for further
references).
13
Gruben et al. (2002) also nd that increases in interindustry trade
which may indicate specializationturn out not to have a signicant
effect on business cycle synchronicity. As pointed out by Imbs (2004a),
specialization is likely to affect the international synchronization of
business cycles. Two economies producing the same types of goods will
be subjected to similar stochastic developments in case of sector-
specic shocks. Countries with similar production patterns will also
react similarly to aggregate shocks. In contrast to Gruben et al. (2002),
Imbs (2004a) nds that similarities in economic structure result in cor-
related business cycles. In other words, specialization reduces business
cycle synchronization. However, the evidence reported by Otto et al.
(2001) is not in line with this view.
There is little agreement whether monetary integration will lead to
more similar business cycles. An argument can be made in both direc-
tions. As suggested by Lamfalussy (1997), monetary integration may
cause more similarity, since there will be less asymmetry in monetary
policy. Also indirectly monetary integration may lead to more syn-
chronization via the impact of exchange rate stability on trade relations.
In a drastic departure from past empirical studies that failed to nd a
signicant link between exchange rate stability and trade, Rose (2000)
reports extremely large positive effects of common currencies on the
volume of trade. The most dramatic, and widely cited, of his ndings
is that two countries sharing the same currency trade three times as
much as they would with different currencies (Rose 2000, p. 7). Roses
estimates of the trade-creating effects of adopting common currencies
are obtained using a gravity model in which bilateral trade is a func-
tion of the relative economic size and distance between two trading
partners. Rose also includes several variables that are intended to
capture trading partners cultural and historical links and membership
in regional trading blocs. The key feature of Roses gravity model is
the inclusion of two monetary variables: a dummy variable to indicate
whether trading partners use the same currency and a measure of the
volatility of the bilateral exchange rate. Glick and Rose (2002) use a
much larger data set and nd that a common currency doubles trade.
14
Other studies, however, arrive at considerably lower effects (see section
6.3.1 for a further discussion).
Monetary integration may also lead to less business cycle syn-
chronization. To the extent that exchange rates are considered as a
shock-absorbing mechanism, xed exchange rates may lead to less
synchronization if the countries in the monetary union face asym-
metric shocks. In face of an external shock, a xed exchange rate regime
requires the central bank to follow a policy so as to maintain the peg,
forcing all the adjustment to take place in the real economy rather than
in the exchange rate.
According to Artis and Zhang (1997), business cycles in Europe were
more similar after the start of the ERM than before, which they inter-
pret as evidence that monetary integration will enhance business cycle
synchronization. Other studies report less support for the view that
exchange rate stability in Europe has led to more synchronization of
business cycles. Frankel and Rose (1998), for instance, include an ERM
dummy variable in their empirical model and nd that its coefcient
is not robust. Also Baxter and Stockman (1989) and Inklaar and De
Haan (2001) report no effect of exchange rate stability on business cycle
synchronization. Furthermore, possible evidence that since the run-up
to EMU there is more business cycle synchronization may not reect
the effect of monetary integration. As pointed out by Darvas and
Szapry (2004), the business cycles of nonEMU European countries
and the United States, and to some extent Japan and Russia, have also
shown greater co-movement with the business cycle in the euro area.
De Haan et al. (2002) have analyzed whether trade relations and
exchange rate stability have affected the synchronization of business
cycles in 18 OECD countries over the years 1961 to 1997.
15
To calculate
the correlation between business cycles they rst detrended the series
with a Hodrick-Prescott lter and calculate correlations of cyclical devi-
ations for the period 1961 to 1997. These authors have estimated the
following simple model:
(5.1)
where p
ij,t
denotes the correlation of the business cycles of countries i
and j during the period t. Dummies (a
0,t
) are included for the four sub-
periods (196173, 197379, 197987, and 198797). The denition of
trade intensity (wt
ijt
) is the same as in Frankel and Rose (1998):
(5.2) wt
X M
X X M M
ijt
ijt ijt
i t j t i t j t
=
+
+ + +
. . . .
,
r a a a m
ij t t ij t ij t ij t
wt v
, , , , ,
log , = + ( ) + +
0 1 2
146 Chapter 5
Table 5.8
Estimates of the relationship between business cycle correlation and trade intensity and
exchange rate volatility
(1) (2) (3)
Constant 44.4 44.6 68.7
(8.45) (4.28) (5.33)
Dummy 19601973 -12.3 -10.0 -7.6
(-3.24) (-2.48) (-1.85)
Dummy 19731979 17.2 16.7 16.9
(4.02) (3.95) (3.97)
Dummy 19791987 0.8 0.6 0.9
(0.25) (0.18) (0.26)
Trade intensity 2.51 3.03
(2.51) (2.87)
Exchange rate volatility 2.52 4.50
(1.23) (2.15)
Source: De Haan et al. (2002).
Note: t-statistics in parentheses, n = 612; all parameters are multiplied by 100.
or the total trade (export X plus import M) between countries i and j
divided by the sum of the trade of each country. The exchange rate
volatility is measured as the standard deviation of the growth rate of
the exchange rate. Their results, shown in table 5.8, suggest that both
higher trade intensity and more exchange rate volatility are related to
synchronization of business cycles. The fact that more exchange rate
volatility leads to more business cycle synchronization may be inter-
preted as support for the view that exchange rates may function as an
adjustment tool. This conclusion is conrmed by the negative sign of
the Bretton-Woods dummy and the positive value of the oating
period dummy. These results suggest that exchange rate uctuations
may reduce asymmetries between countries.
Also nancial integration has been argued to affect business cycle syn-
chronization. As pointed out by Imbs (2004a), the impact of nancial
integration on synchronization is not unambiguous. On the one hand,
a limited ability to borrow and lend internationally hampers the trans-
fer of resources across countries and can increase GDP correlations. If,
on the other hand, investors have imperfect information or face liqui-
dity constraints, limiting capital ows can decrease GDP correlations,
as investors herd (or withdraw) capital from many destinations simul-
taneously. Financial integration may also lead to specialization, and
therefore less synchronicity. Using a variety of alternative measures of
nancial integration, Imbs (2004a) nds evidence that economic
regions with strong nancial links are signicantly more synchronized.
Interestingly Imbs (2004a) obtains similar estimates across US states
and across countries with substantially different monetary policies,
suggesting that the synchronization of business cycles is not an artifact
of an international convergence of monetary policy making. Imbs con-
cludes that the positive direct effect of nance on synchronization dom-
inates the negative indirect effect, working via higher specialization.
Using some new indicators for nancial integration (including bilateral
asset holdings), Imbs (2004b) reports that apart from an inuence on
goods trade, nancial liberalization has a direct positive effect on busi-
ness cycle synchronization. Jansen and Stokman (2003) nd that capital
ows have played a role in synchronizing business cycles in recent
years. For a sample of industrial countries in the period 1995 to 2001,
they report that FDI linkages can explain the pattern of international
business cycle linkages even better than foreign trade relations.
Finally, Clark and van Wincoop (2001) suggest that the presence of
borders matters when it comes to business cycle synchronization. They
nd for the four largest European countries that within-country corre-
lations are substantially larger than cross-country correlations. These
results continue to hold after controlling for exogenous factors such as
distance and size. They nd that the lower level of trade between Euro-
pean countries, and, to a lesser extent, the higher degree of sectoral spe-
cialization, can explain most of the observed border effect.
Artis (2003) also examines which factors affect business cycle aflia-
tion, departing from the idea that business cycles are the result of orig-
inating shocks feeding into a propagation mechanism. Asynchronous
cycles may therefore arise from the interraction of different (nonsym-
metric) propagation mechanisms with common shocks just as much as
they arise from asymmetric originating shocks with similar kinds of
propagation mechanisms at work. For instance, more or less exible
labor markets will make for less or more persistence in the response to
a shock. On the basis of panel data estimation using averages over
three periods (197079, 198092, and 19932001) Artis (2003) concludes
that the variables relative nancial structure (measured as the ratio
of private credit to stock market value traded) and relative share of
oil imports are signicant with a negative sign. Relative labor
market exibility is not signicant, while the role of trade is more
ambiguous.
148 Chapter 5
On the basis of the foregoing analysis, we conclude that there is still
no consensus on whether business cycles of the countries in the euro
area have become more similar recently. This is due to the use of dif-
ferent data and methods of identifying business cycles and assessing
convergence. There are various factors that may affect business cycle
synchronization, such as trade relations, specialization, monetary inte-
gration, nancial relations, and the presence of borders. There is con-
siderable support for the notion that trade intensity enhances business
cycle synchronization, but the effect of trade specialization on business
cycle synchronization is less accepted. There is little agreement whether
monetary integration and nancial integration will lead to more similar
business cycles. The presence of borders is likely to matter for business
cycle synchronization.
5.5 Different Ination Rates in the Euro Area
Ination differentials in the euro area have increased recently. As
pointed out by Remsperger (2003), in the convergence and start-up
phase of EMU, the average annual rate of ination in Austria, France,
and Germany was 0.8 percent. At that time the critical 2.3 percent mark
(1.5 percent above the ination in the three best-performing countries)
was not being overshot by any country. Between 2000 and 2002 Austria,
France, and Germany again had the lowest ination in the euro area,
although their average ination rate was now 1.8 percent. Together
with the margin allowed by the ination criterion, this produced a crit-
ical value of 3.3 percent. The ination in no fewer than three founding
members of the monetary unionIreland, the Netherlands, and
Portugalexceeded that level.
Ination differentials in the euro area since the beginning of 1999
have been quite marked. Notably Ireland, Spain, Greece, and Portugal
have been persistently at the top of the ination league table; also price
increases in the Netherlands were generally higher than average ina-
tion in the euro area. In contrast, German ination has been below the
euro area average (see table 5.9).
16
Viewed over a longer time period, the degree of ination dispersion
in the euro area, measured in terms of the standard deviation,
decreased over time, especially during the second half of the 1990s. The
unweighted standard deviation declined from around 4 percentage
points at the beginning of the 1990s to about 1 percentage point at the
start of the monetary union (ECB 2003b).
According to the ECB (2003b), the current degree of ination dis-
persion in the euro area is close to that observed in the United States.
However, as we pointed out in chapter 3, owner-occupied housing
is included in the US CPI but not in the European HICP. As argued
by Remsperger (2003), this is important because there is hardly any
other component where regionally divergent price developments have
such a major impact as they do in housing. The interregional standard
deviation of the changes in rents is greater than that of services, which,
in turn, is larger than that of industrial goods (excluding energy).
House prices increased by 10 percent a year and more in Ireland, the
Netherlands, and Spain while less in other countries. Thus, if owner-
occupied housing were included in the HICP, the divergence of ina-
tion rates in the euro would take a sharp rise, perhaps even exceed the
dispersion of ination rates in the United States. Also the ination
differentials in the euro area are more persistent than those in the
United States.
Ination differentials are caused by many factors, including differ-
ent consumption patterns, scal policies, differences in the dependence
on trade, convergence of price levels of traded goods across euro area
countries, different productivity developments, and diverging business
cycles. We will discuss each factor in turn.
Differences in ination rates in the monetary union due to consump-
tion patterns may be attributed to differences in the shares of
Table 5.9
Ination differentials relative to the euro average, 19902002
19901993 19941998 19992002 1999 2000 2001 2002
Austria -0.8 -0.4 -0.4 -0.6 -0.4 -0.2 -0.5
Belgium -1.1 -0.4 -0.1 0.0 0.4 0.0 -0.7
Finland 0.3 -0.9 0.2 0.2 0.6 0.2 -0.2
France -1.1 -0.5 -0.5 -0.6 -0.5 -0.7 -0.3
Germany -0.6 -0.6 -0.6 -0.5 -0.7 -0.5 -0.9
Greece 12.9 5.4 1.1 1.0 0.6 1.2 1.7
Ireland -1.6 0.3 2.1 1.3 2.9 1.5 2.5
Italy 1.6 1.5 0.3 0.5 0.3 0.2 0.4
Luxembourg -0.6 -0.6 0.3 -0.1 1.5 -0.1 -0.2
Netherlands -1.4 -0.3 1.3 0.9 0.0 2.6 1.7
Portugal 6.0 1.2 1.2 1.0 0.5 1.9 1.4
Spain 1.9 1.3 1.2 1.1 1.2 1.2 1.4
Source: ECB (2003b).
150 Chapter 5
individual consumer goods and services in total consumption across
countries. The weights used in calculating HICP in the separate coun-
tries are only harmonized; they do not reect the actual consumption
baskets of these countries. So there are differences between the calcu-
lated ination rates and the actual ination rates. However, research
by the ECB (2003b) indicates that differences in consumption patterns
across the euro area countries do not have a major impact on ination
dispersion. Also the prices of the same goods may show different
developments across countries as they may be administered. Prelimi-
nary estimates by the ECB (2003b) suggest nevertheless that the mag-
nitude of the impact of administered prices on ination dispersion in
the euro area has been relatively small in the period 1999 to 2002.
Countries in the euro area may experience different ination rates
due to differences in their scal policies. Although the scope of national
scal policy is limited by the Stability and Growth Pact, it can put pres-
sure on ination. According to Hendrikx and Chapple (2002), for
instance, VAT and energy tax increases in 2001 led to an increase of the
ination rate in the Netherlands of approximately 1 percentage point.
These indirect tax effects should be temporary as they represent a one-
off change in the price level. In their empirical estimates of ination
differentials in the euro area, Honahan and Lane (2003) did not nd
much evidence that national scal policy differences contributed to the
ination dispersion.
Likewise differences in dependence on trade may lead to ination dif-
ferentials. The nominal effective exchange rate of the euro had declined
by about 20 percent in October 2000, before recovering in the period
from 2001 to 2003. The impact of exchange rate shocks on consumer
prices is determined by the share of imported goods in private con-
sumption and the strength of the pass-through effect. As pointed out
in section 3.6.1, the pass-through is not uniform across the countries in
the euro area. Price developments may therefore differ in the short to
medium term even with uniform shocks.
One important factor inuencing pass-through is the openness
toward trading partners outside the euro area. In general, extra-
openness should be reected by a higher weight of extraeuro area
goods in a countrys overall goods basket and, therefore, a stronger
pass-through effect from exchange rate changes on domestic prices
(ECB 2003b). A member country that depends on imports from a non-
member country will experience different inationary pressures if the
euro exchange rate depreciates as compared to a member country that
conducts all its trade with other member countries (Hfner and
Schrder 2002). In addition to the direct impact of exchange rates on
consumer prices, there may be a cyclical effect of exchange rate shocks
via a change in the competitive position, which is also determined by
an economys degree of openness to countries outside the euro area.
The econometric estimates of the ination differentials of Honahan and
Lane (2003) suggest a signicant role for effective exchange rate
changes. Their point estimate implies that a relative deprecation of 3.5
percent is associated with an additional 1 percentage point of ination.
This is a large effect. The Irish nominal effective exchange rate depre-
ciated 11 percent during 1998 to 2000, while the French exchange rate
weakened by only 4 percent. According to these estimates, differences
in the effective exchange rates of Ireland and France led to an ination
differential of 2 percentage points in this period.
Most of the differences in the effective exchange rate across countries
in the euro area reect differences in their trade patterns. However,
as pointed out by the ECB (2003b), euro area countries with similar
degrees of extra-openness had very different ination rates, indicat-
ing that other factors are also important for the divergence of ination
in the euro area. One such factor is also related to trade: differences in
oil dependency. Oil prices tripled in 1999 and 2000. Since countries in
the euro area differ in terms of oil dependency, oil price changes may
also have led to ination differentials. However, research by the ECB
(2003b) suggests that the relationship between oil dependency and
ination differentials is rather weak.
Countries in a monetary union share the same currency but need not
have the same price level. If price levels differ initially across countries
forming a monetary union, then price level convergence will generate
temporary ination differentials (Duarte 2003). Existing research for
the United States suggests that price level differences can be persistent.
For instance, using consumer price data for nineteen US cities from
1918 to 1995, Cecchetti et al. (2002) report that price level differences
were large and persisted by as much as 1.55 percentage points
in annual ination rates measured over ten-year periods. Similarly
Parsley and Wei (1996) employ commodity level price data for 48 US
cities from 1975 to 1992 and nd persistent deviations from the law of
one price for both traded and nontraded goods.
In the European Union, price levels differ across countries. Accord-
ing to the European Commission (2002b), indirect taxation, the struc-
ture of distribution networks, market power or competition, and
152 Chapter 5
inefcient services sectors are the main factors accounting for much of
the remaining differences in the prices of tradable goods. At least some
convergence of price levels of traded goods has already occurred in the
euro area. Increased market integration and price transparency associ-
ated with the adoption of a common currency will further reduce the
scope for deviations from the law of one price. Rogers (2001) has exam-
ined price level convergence, using a unique data set of prices of 168
goods and services across 26 European cities in 18 countries between
1990 and 1999. There was evidence of convergence for traded goods in
the rst half of the 1990s but none of convergence for nontradables over
the decade. Table 5.10 is reproduced from this study. The empirical esti-
mates by Rogers (2001) for ination differences across Europe show
that countries with low prices in 1999 experienced higher overall ina-
tion in 2000. Rogers also obtained data for US cities, which provides a
useful comparison, since the United States has long been a functioning
monetary union. Rogers found little evidence of an active process
toward price convergence across US cities. More recently Honahan and
Lane (2003) nd that a considerable part of the ination differentials in
the euro area can be explained by price level convergence. Their point
estimate indicates that a country with a price level one-third below the
European average will experience an additional 1 percentage point of
ination.
17
Thus ination of traded goods prices and nontraded goods prices,
or both, can bring relatively high ination to countries with low prices
following economic integration. Since price level convergence works
mostly through tradables, some of the current divergence of ination
Table 5.10
How much have prices in the euro area converged?
Standard deviation of prices across locations
Price index 1990 1995 1999
Euro Area
Overall 0.12 0.12 0.11
Tradables 0.12 0.08 0.06
Nontradables 0.27 0.33 0.31
United States
Overall 0.16 0.15 0.17
Tradables 0.05 0.04 0.04
Nontradables 0.51 0.52 0.57
Source: Rogers (2001).
in the euro area may be transitory. However, to the extent that price
level convergence occurs through the relatively gradual process of con-
vergence of productivity and living standards, the resulting cross-
country ination differentials may be long-lived (see Rogers 2001).
The Balassa-Samuelson effect (Balassa 1964; Samuelson 1964) suggests
that prices of nontraded goods may converge as well. In a convergence
of productivity levels, the initial low-productivity low-price level coun-
tries will experience faster productivity growth and price rises com-
pared to the high-productivity high-price level countries. To show this
mathematically, we take the simple model of a two-country world, both
countries operating with a small open economy, two commodities, one
scarce factor (labor), and constant input coefcient technology. We
assume that the prices of nontradables are not equalized across coun-
tries. Another crucial assumption is that the growth rate of real wages
in the traded goods sector is determined by the growth rate of labor
productivity. So
(5.3)
where a, p, and wstand for changes in productivity, prices, and nominal
wages, respectively, while the superscripts T and NT refer to the trad-
able and nontradable sector. Ination in tradables is the same due to
international trade arbitrage:
(5.4)
where the asterisk denotes the foreign country and e denotes the
change in the exchange rate. It is assumed that wage increases in both
sectors are the same so that
(5.5)
Say that over time the productivity growth in the tradable goods sector
of a country exceeds that in the nontradable goods sector. Clearly,
higher productivity growth in the traded goods sector will entail higher
wages in both sectors. Let ination be dened as the weighted sum of
the tradables and nontradables price ination, with a and (1 - a) the
traded goods and nontraded goods sectors share in GDP:
(5.6)
Now assume that a a*. The ination differential between the home
and foreign country can then be written as
p ap a p =
T NT
+ -
( )
1
a a
NT NT T T
+ = + p p ,
p p e
T T
= +
*
,
w a
T T T
- = p ,
154 Chapter 5
(5.7)
We see in (5.7) that the difference between the ination rates equals the
rate of depreciation of the nominal exchange rate plus the (common)
share of nontraded goods in the consumption basket, multiplied by the
excess of the productivity growth differential between the traded and
nontraded goods sectors in comparison to this productivity differential
abroad. The high ination that results from rapid productivity growth
in the traded good sector is nothing more than an equilibrating
mechanism. Without this equilibrating mechanism the country with
high productivity growth would gain competitiveness and accumulate
current account surpluses.
The Balassa-Samuelson effect can explain ination differentials in a
monetary union if the countries in this union show large difference in
income per capita. The euro area includes many economies in which
GDP per head is considerably below the EU average. In these so-called
catching-up countries, productivity, especially in manufacturing, is likely
to grow faster than in the other EMU countries. The resulting sector
price increases inuence relative prices and push ination to levels
above those recorded in more advanced economies.
According to De Grauwe and Skudelny (2000), the prices of non-
traded goods grew faster than the prices of traded goods in all EMU
countries because labor productivity growth in the tradable goods
sector exceeded labor productivity growth in the nontradable goods
sector. Figure 5.2 shows the average productivity growth over the
period 1971 to 1995 as reported by these authors.
p p e a - = + - ( ) - - ( ) [ ] * * * . a a a a
T NT T NT
5
4
3
2
1
0
A BL DK FIN FR GE IT NL PO SP SW UK
T
NT
Figure 5.2
Average productivity growth in European countries (%), 1971 to 1995. (Source: De
Grauwe and Skudelny 2000)
Co-integration tests for 11 EU countries for the period 1975 to 1995
by Alberola and Tyrvinen (1998) suggest that sustained ination
differentials of 2 percentage points exist between the more and
less advanced euro countries due to the Balassa-Samuelson effect.
However, De Grauwe and Skudelny (2000) nd in their panel estimates
for the period 1970 to 1995 for 12 EU countries that the average bilat-
eral ination differential caused by the Balassa-Samuelson effect gen-
erally does not exceeded 1 percentage point. These authors also
estimated the maximum bilateral ination differentials due to the
Balassa-Samuelson effect. The calculations showed that the ination
differential can go up to 8 percent in absolute value.
Sinn and Reutter (2001) also estimated the contribution of the
Balassa-Samuelson effect to ination differentials, but they found for
most countries a smaller impact. To construct a complete sample for all
members of the currency union, they had to restrict the tradable goods
sector to agriculture and manufacturing and treat the remainder as the
nontradable goods sector (construction, services, electricity, gas and
water supply). Ination rates were higher in countries where the inter-
sectoral growth difference was higher (see equation 5.7). To avoid dea-
tion in any one of the countries, the aggregate ination rate for all
countries taken together must rise as countries become more diverse
in their productivity differentials. The following equation serves as the
basis for the empirical estimates of Sinn and Reutter (2001):
(5.8)
Here
min
is the minimum aggregate ination rate compatible with the
requirement that no single country will face a deation, b
i
is country
is share in aggregate value added, a
i
NT
is the share in value added pro-
duced by country is sector of nontraded goods and (a
i
T
- a
i
NT
) is the
change in the marginal product of labor in the traded goods sector
minus the change in the marginal product of labor in the nontraded
goods sectors of country i.
Equation (5.8) can be explained as follows: Imagine a fully developed
industrial country, such as Germany, whose manufacturing sector
enjoys no particular productivity gains relative to the nontraded goods
sector (no change in relative prices) and the relative prices of nontrad-
able goods is rising in all other countries. The price of traded goods
cannot fall without generating a deation in this industrially mature
p
p b a a
min
,...,
min . = - ( ) - - ( ) [ ]
=
=
i
i
n
i i i
i n
i i i
a a a a
1
1
NT T NT NT T NT
156 Chapter 5
country. The aggregate price level must rise so as to accommodate for
the required increases in the relative prices of nontraded goods in the
other countries that result from the productivity increases in the traded
good sectors. This is covered by the rst term on the right-hand side
of the equation. To understand the second term on the right-hand side
of the equation, consider that even the most industrially mature
country can experience some extra productivity growth in the traded
goods sector. The price of traded goods can fall in this country without
effecting a deation because of compensation from the increase in the
price of nontraded goods. As a consequence the no-deation constraint
is relaxed. Because the price of traded goods is falling, the relative price
of nontraded goods can increase in all countries without implying as
much ination as before (Sinn and Reutter 2001).
As pointed out by the ECB (2003b), it is difcult to isolate the Balassa-
Samuelson effect from other historical inuences on ination, in
particular, differences in monetary and exchange rate policies across
countries. There is actually a large spectrum of estimates of Balassa-
Samuelson effects and contradicting results for individual countries. In
table 5.11 we present a summary of studies on the importance of the
Balassa-Samuelson effect in the euro area (recalculated for euro area
ination of 2 percent), including the studies that are discussed here.
Although these studies are not all directly comparable because of dif-
ferences in methodology and sample periods and because of a wide
variety of results, some broad patterns are discernible. For instance,
Germany and France are generally below the average, while Greece
and Ireland are above the average. This result is broadly consistent
with the fact that catching-up countries can expect to experience a real
appreciation. Nevertheless, there is the slim chance, as pointed out by
the ECB (2003b), historically, that their catching-up will not in every
case lead to high ination or an appreciating nominal exchange rate, as
is the case of Ireland. Indeed, as Honahan and Lane (2003) convincingly
argue, little, if any, of the Irish ination deviation is a reection of the
Balassa-Samuelson effect. Irelands boom has been apparently largely
due to employment growth, and not exceptional productivity gains.
Furthermore some of the estimates of the Balassa-Samuelson effect are
not in line with actual ination after the start of the monetary union.
For instance, Belgium and Finland are sometimes found to have high
Balassa-Samuelson effects, but this is not conrmed by actual ination
differences. Conversely, the Netherlands has had a higher ination dif-
ferential than predicted by the Balassa-Samuelson model (ECB 2003b).
C
e
n
t
r
a
l
i
z
a
t
i
o
n

o
r

D
e
c
e
n
t
r
a
l
i
z
a
t
i
o
n
1
5
7
Table 5.11
Equilibrium ination rates implied by Balassa-Samuelson effect according to selected studies
Alberola and Average HICP
Tyrvinen HICP IMF (1999) Canzoneri et al. De Grauwe Sinn and ination
Sample 19751995 Proxy IMF
a
19601996 19731997 and Skudelny Reuter
b
19871995 19952002
c
Belgium 3.1 2.0 3.8 2.6 2.1 1.8 1.7
Germany 1.3 1.9 1.5 1.0 1.7 1.0 1.2
Greece 2.7 2.8 5.3 3.8
Spain 3.1 2.3 2.4 2.0 2.5 3.0
France 1.7 1.9 2.8 2.4 1.6 2.3 1.5
Ireland 3.4 3.0 3.4 3.1
Italy 2.4 1.9 2.7 2.8 2.4 2.5 2.8
Netherlands 2.3 2.3 1.6 2.0 2.4 2.5
Austria 1.8 2.5 1.8 2.5 2.4 1.5
Portugal 2.7 4.3 2.1 1.8 3.0
Finland 2.3 2.9 2.6 1.4 3.7 1.6
Euro area 2.0 2.0 2.0 2.0 2.0 2.0 1.9
Standard deviation 0.6 0.4 0.9 0.6 0.4 1.1 0.9
Source: ECB (2003).
Note: Euro area ination normalized to 2 percent.
a. The IMF (2002) calculates an HICP proxy, which assumes that the historical trend differential between price developments of industrial goods
and services between 1995 and 2001 remains the same. This measure is immune to some of the criticism of the other BS studies as it relies directly
on observed ination rather than on productivity differentials. However this analysis also entails an important caveat in that it is based on a
short period, which does not comprise a complete business cycle, and therefore may be biased.
b. Sinn and Reutter (2001) assume that historical productivity differentials will be reected in equally large ination differentials between sectors.
Most other studies do not nd a unitary relationship, implying that the dispersion found by Sinn and Reutter is likely to be upward biased.
c. Greece since 1997.
158 Chapter 5
The Balassa-Samuelson hypothesis is based on the assumption that
PPP holds in the long run in the traded goods sector. Furthermore rel-
ative prices of the nontraded and traded sectors are assumed to mainly
depend on the different evolution of productivity in the two sectors.
Ortega (2003) has investigated whether such long-run hypotheses can
be accepted across the main European economies (Germany, France,
Italy, and Spain). The sample period covers 1970 to 2001 for Italy and
Germany, 1978 to 1999 for France, and 1986 to 2001 for Spain. She nds
that deviations from PPP are persistent for the sample periods under
consideration, although somewhat less than is typically found in the
literature. Ortega splits up the real exchange rate into that of the traded
sector and the differential across countries of the relative price of the
nontraded sector. The latter is further broken into its determinants,
namely the cross-country differentials of relative markups, relative
labor costs, and relative labor productivities. Ortega nds that the
driving forces of the relative price differentials differ across countries
and periods. They persistently diverge from the predictions of the
Balassa-Samuelson hypothesis.
Business cycle differences may also contribute to the ination differen-
tials in the euro area. As we pointed out in the previous section, busi-
ness cycles diverge among the countries in the euro area. Countries
with output above trend tend to have upward pressure on ination,
while countries with output below trend will experience downward
pressure on ination. Figure 5.3 plots the average ination rate after
the euro was adopted in each euro area country against its average
output gap in the same period. The plot suggests a positive relation-
ship between the average output gap and average ination.
Business cycles can be out of sync for various reasons. Remsperger
(2003) argues that one reason could have been the nominal convergence
process in the run-up to EMU. The elimination of the residual foreign
exchange risk since the beginning of 1999 and the dwindling of the risk
premia brought about a largely uniform interest rate level on capital
markets. In some countries this could have generated a substantial eco-
nomic boost. It was exactly in those countries that already had rela-
tively high ination that the fall in real interest rates pushed up prices.
18
An important factor was the rapid rise in property prices encouraged
by the convergence of interest rates (Remsperger 2003). Indeed,
Honahan and Lane (2003) report a fairly strong negative cross-sectional
correlation between real interest rate declines in the run-up to EMU
and commercial property ination in 1995 to 2001 (the correlation is
-0.67). This source of ination differentials is only temporary. The
expansionary effects of real interest rate changes over time are offset
by the equilibrating effect of changes in national competitiveness trig-
gered by an increase in ination differentials.
Ination differentials among economies in a monetary union lead to
changes in their real exchange rates. Owing to a real appreciation,
countries with higher-than-average ination rates suffer a loss in price
competitiveness, while countries with relatively low ination rates gain
in price competitiveness. The consequence is that export demand in the
countries with higher ination rates tends to decline, which has a damp-
ening effect on prices in these countries. Conversely, demand tends to
increase in countries with lower ination rates. The coolant effect of real
appreciation through a loss of competitiveness is likely only to operate
at a gradual pace. This persistence mechanism is reinforced if the wage-
setting process is not perfectly exible, such that current rather than
prospective ination inuences wage determination (Honahan and
Lane 2003). Arnold and Kool (2002) have examined the regional ina-
tion dispersion in the United States. They nd that the pro-cyclical
impact of a lower real interest rate dominates the countercyclical impact
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
-2 -1 0 1 2 3 4 5
Average output gaps
A
v
e
r
a
g
e

i
n
f
l
a
t
i
o
n
Figure 5.3
Output gap and ination, 1999 to 2002. (Source: OECD, Economic Outlook)
160 Chapter 5
of the real exchange rate in the short term. So, when regional ination
differentials occur, initially they tend to increase.
In conclusion, like in other monetary unions, ination differentials
exist and are likely to remain in place in the European Monetary
Union. From our review of the literature we nd that despite the pop-
ularity of the Balassa-Samuelson argument, the evidence in support of
it is not very compelling. Other factors, like different reactions to the
development of the external value of the euro, price level convergence,
and diverging business cycles seem to be more important. Regional
ination dispersion appears to be an adjustment mechanism through
which regional economic imbalances are corrected. Ination differen-
tials can, however, become problematic in two instances. First, if the
composition of the group of countries with above average ination
remains constant, the political support for monetary union and the
ECBs policies will likely erode in these countries. This can put
pressure at national central bankers. Second, if an ination differential
in a particular country is transitory, it can be a potentially dangerous
trigger of persistence mechanisms that continue to operate after the
original shock has disappeared. Overshooting can occur through
pricewage dynamics, especially if current ination feeds into future
wage growth (Honahan and Lane 2003). There may be differences in
the way expectations are formed across the euro area countries. Accord-
ing to Benigno and Lopez-Salido (2002) the expectation formation in
the wage- and price-setting process in Germany has been forward-
looking, whereas in other countries it has been geared more to the past.
This can have a signicant impact on price dynamics and give rise to
ination differentials as pointed out by Remsperger (2003). For
example, an oil price shock that affects wages in one country because
its expectation formation is oriented to the past does not necessarily
affect wages in other countries, so temporarily this situation creates
ination differentials.
5.6 Differences in Monetary Policy Transmission and Financial
Structure
It may be difcult for the ECB to keep ination in the medium term
below 2 percent if the impacts of monetary policy decisions differ
across countries in the euro area. Many critics of EMU have considered
the differences in monetary transmission across countries in the euro
area as an (additional) argument against a common currency.
In this section we examine two aspects of monetary transmission.
First, we review in section 5.6.1 recent research on the so-called pass-
through of monetary policy decisions (the extent to which changes in mon-
etary policy interest rates are reected in market interest rates). Among
other things, the impact of monetary policy on the real economy
depends on how changes in policy rates are transmitted to market
interest rates. Two elements are crucial for the transmission of mone-
tary policy decisions: the degree to which changes in the policy rate
affect the cost of borrowing and the speed of adjustment of market rates
to changes in policy interest rates. We analyze to what extent the pass-
through of policy interest rates differs across countries in the euro area
and whether there is convergence of the pass-through.
Second, we examine recent studies in which asymmetries in monetary
policy transmission are related to differences in nancial structure. The
best-known study in this area is by Cecchetti (1999, p. 22), who argues:
Most economists believe that the monetary transmission mechanism will vary
systematically across countries with differences in the size, concentration, and
health of the banking system, and with differences in the availability of primary
capital market nancing. The countries of the EU differ quite dramatically in
all of these dimensions that would seem to matter, leading to the prediction
that the impact of interest rates on output and prices will not be consistent
across countries. While the estimates of the impact of interest rate changes on
output and ination tend to be quite imprecise, they do differ, and in the way
that is predicted by the state of the countries nancial systems.
In contrast, in summarizing a large project on differences in monetary
transmission across euro area countries, the ECB concludes in its
Monthly Bulletin of October 2002 that the empirical evidence does not
suggest that there are systematic differences among countries in policy
transmission that are robust across different studies and methodolo-
gies. In section 5.6.2 we analyze this issue in some detail.
5.6.1 Pass-through of Monetary Policy Decisions
Various studies have investigated the pass-through empirically in a
multicountry setting. Cottarelli and Kourelis (1994) report important
differences in pass-through in EMU countries. Table 5.12 shows their
estimates of the short-term (initial) effect for the six biggest EU coun-
tries. Also the results of similar studies by Borio and Fritz (1995), BIS
(1994), and Mojon (2000) are presented in this table. Mojon (2000) exam-
ines the pass-through in these six EMU countries for the period 1979
to 1998 for a whole range of deposit and credit rates (but which cannot
162 Chapter 5
be fully compared across countries) and conrms the conclusion of
heterogeneity of previous studies. Hofmann (2002) analyzes the pass-
through in France, Germany, Italy, and Spain over the period 1984 to
1998, using the Johansen co-integration analysis. He concludes that
innovation in the money market rate is fully passed through to short-
term and long-term business loan rates over time. In the short run the
response of lending rates is, however, sluggish.
Although the EMU countries now share the same currency, their
nancial systems show considerable differences. As pointed out by
Mojon (2000), national segmentation in the retail banking industry will
remain signicant despite the EMU because retail banking involves
heavy investments in advertising, in a network of ofce branches, and
in customer services. Also differences in regulation can cause retail
banking markets to remain segmented along national lines. Then there
are differences in the balance sheet structure of households and rms
as they only gradually adjust to the new monetary regime. As a con-
sequence the pass-through from policy-controlled interest rates to bank
interest rates will tend to remain country specic. This potential source
of asymmetry in monetary transmission is particularly relevant in the
euro area where bank rates are a key determinant of the cost of capital
and the yield on savings.
Toolsema et al. (2002) examine this issue in some detail using rolling
regression techniques in an error correction framework. These authors
estimate their model rst for the period 1980 to 2000, and then apply
rolling regressions. The idea behind the latter approach is to take a
Table 5.12
Short-run and long-run effects of policy rate increase of 100 basis points on lending rate
(basis points)
Belgium Germany Spain France Italy Netherlands
Cottarelli and 21 37 36 12 52
Kourelis (1994) 87 100 94 83 82
Borio and Fritz 61 11 0 43 26 108
(1995) 127 105 117 74 122 108
BIS (1994) 85 18 43 14 125
Mojon (2000) 96 68 65 86 50 99
Note: Top row shows the short-run effect, and next row the long-run effect. The BIS and
Mojon studies only report short-run multipliers. The short-run effect refers to impact
multipliers for Cottarelli and Kourelis (1994), and BIS (1994), to one-month multipliers
for Borio and Fritz (1995), and to three-month multipliers for Mojon (2000). For the latter
we report the multipliers that refer to short-term loan rates.
xed number of observations and to redo the regressions, every time
adding one observation at the end of the sample while dropping one
at the beginning. The results indicate whether the monetary policy
transmission has been stable over time in the country under consider-
ation and whether or not convergence has occurred. They nd that the
long-term equilibrium multipliers in all countries have moved toward
similar levels. In other words, this evidence suggests that there is con-
vergence of long-term multipliers. This process is visible in windows
that start at the end of the 1980s.
Over all, most recent evidence on pass-through of monetary policy
suggests that there has been a tendency toward convergence, although
it is unclear to what extent differences as reported in the earlier litera-
ture have fully disappeared. In this regard Mojon (2000) and Toolsema
et al. (2002) conclude that some differences still exist, whereas Hoffman
(2002) nds that monetary policy changes are fully transmitted to
market rates in all countries in his sample.
5.6.2 Monetary Transmission and Financial Structure
There is plenty of evidence that monetary policy has a diverging effect
on many countries in the euro area (e.g., see Rawaswamy and Slk
1998). Anumber of studies claim that asymmetries in monetary policy
transmission in the euro area result from differences in nancial struc-
ture (e.g., see Dornbusch et al. 1998; Cecchetti, 1999). Cecchetti (1999)
bases his view on the lending view of monetary policy transmission,
according to which monetary policy actions change the reserves avail-
able to the banking system, thereby affecting the willingness of banks
to lend and, ultimately, the supply of loans. Countries in which rms
are more bank dependent and banking systems are less healthy will be
more sensitive to ECB interest rate changes. Cecchetti (1999) relates the
estimates of monetary policy impact on output and ination of Ehrman
(1998) to indicators for nancial structure. He nds that countries with
many small banks, less healthy banking system, and poorer direct
capital market access display a greater sensitivity to monetary policy
changes than do countries with big, healthy banks and deep, well-
developed capital markets. Table 5.13 is reproduced from Cecchetti
(1999).
The nal column in table 5.13 shows the predicted effects of mone-
tary policy on output and ination, with higher values indicating a
stronger lending channel and therefore a larger impact. The indicator
is an average of the rst three columns. The rst column summarizes
164 Chapter 5
Cecchettis assessment of the importance of small banks, which is based
on more detailed information on the number of banks, the number of
banks per million population, and the concentration ratio for the top
ve banks. The second column summarizes indicators for the health of
the banking system (return on assets, loan loss provisions, net interest
margin, and operating costs). The scores as reported in the third
column are based on the number of publicly listed rms, the extent of
secondary equity and debt markets, and the ratio of bank loans to all
forms of nance.
Table 5.14 connects the predicted effect to the estimated effects in the
model of Ehrmann (1998) as reported by Cecchetti (1999). It is remark-
able thatin contrast to what Cecchetti (1999) suggeststhe linkage is
not very strong. Indeed, if we plot Cecchettis indicator for nancial
structure and the estimated impact on production growth, a positive,
but insignicant effect shows up (see gure 5.4). So the evidence is that
differences in nancial structure do not cause much difference in mon-
etary transmission. This conclusion is broadly in line with the outcomes
of a Eurosystem research project, which is summarized in sidebar 12.
Table 5.13
Summary of factors affecting the strength of the monetary policy transmission
mechanism
Predicted
Importance of Bank Availability of effectiveness of
small banks health alternative nance monetary policy
Country (1) (2) (3) (4)
Austria 3 2 3 2.67
Belgium 1 2 1 1.33
Denmark 2 2 1 1.67
Finland 1 3 2 2.00
France 2 3 2 2.33
Germany 3 2 2 1.67
Greece 2 2 3 2.33
Ireland 1 1 3 1.67
Italy 2 3 3 2.67
Netherlands 1 2 2 1.67
Portugal 1 3 3 2.33
Spain 2 2 2 2.00
Sweden 1 3 3 1.67
United Kingdom 1 1 1 1.00
Source: Cecchetti (1999).
Table 5.14
Predicted and estimated effects of monetary policy
Predicted effectiveness
Maximum impact on
Country of monetary policy Output Ination
Austria 2.67
Belgium 1.33 -0.72 -0.05
Denmark 1.67 -0.48 -0.34
Finland 2.00
France 2.33 -1.30 -0.21
Germany 1.67 -1.21 -0.48
Greece 2.33
Ireland 1.67 -0.76 -0.25
Italy 2.67 -0.64 -0.25
Netherlands 1.67
Portugal 2.33 -0.39 -0.28
Spain 2.00 -0.46 -0.23
Sweden 1.67 -0.56 -0.11
United Kingdom 1.00 -0.53 -0.37
Note: Second column reproduces column 4 of table 5.13; the third and fourth columns
show the maximum impact of a 100 basis point increase in interest rates as reported by
Cecchetti (1999) on output and ination.
y = 0.1976x + 0.3295
R
2
= 0.109
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0 0.5 1 1.5 2 2.5 3
Financial structure indicator
M
a
x
i
m
a
l

o
u
t
p
u
t

e
f
f
e
c
t
Figure 5.4
Financial structure and impact of monetary policy
12 Differences in Monetary Policy Transmission: The ECB
View
In its Monthly Bulletin of October 2002 the ECB reports on a large-scale
research project on monetary transmission in the euro area.
19
As pointed
out by the ECB, there are two approaches to determining the importance
of the different channels in affecting the evolution of prices and output
in the euro area. On the one hand, structural econometric models can be
used to try to disentangle some of the channels and identify their rela-
tive quantitative importance at the macroeconomic level. A drawback is
that the analysis is dependent on the model, and the result can be driven
partly by modeling choices. On the other hand, disaggregated data from
balance sheets of nonnancial rms and banks can be used to analyze
specic key links in the transmission mechanism, such as the role of
nancial factors and the supply of bank credit. This approach is promis-
ing because of the importance of bank lending as a source of nance in
the euro area. With this type of research, however, it is not always easy
to deduce the macroeconomic importance of evidence in favor of nan-
cial factors playing a role. Both approaches have been used in this project.
The main results of the research can be summarized as follows:
Investment seems to be an important driving force behind output
changes in the wake of a monetary policy shock. The results conrm that
business investment is sensitive both to changes in the user cost of capital
and, to a more limited extent, to liquidity or cash-ow effects. Financial
and credit constraints seem to play a role in explaining the response to
monetary policy in some countries and for specic groups of rms or
banks but are not of central importance for the euro area as a whole. The
empirical evidence does not suggest that there are systematic differences
among countries in policy transmission that are robust across different
studies and methodologies. However, there is evidence for diverging
monetary policy measures affecting economic sectors and also evidence
that the effects of monetary policy on output is stronger in periods when
the balance sheets of households and rms are weak, such as during a
downturn.
A number of studies have used large-scale macroeconomic models at
the disposal of the European Central Bank and the national central banks
of the Eurosystem to compare the effects of monetary policy. Table 5.15
gives the results of a common monetary policy experiment with these
econometric models, using a 100 basis point rise in the policy interest
rate over two years. As the results show, this measure is found to lead to
a maximum aggregate drop in output in the national models of about 0.4
percent after two years. Asimilar effect is found for ination, but in this
case it occurs two years later. There are some notable variations in the
results across models with respect to both the magnitude and timing of
the effects. The impacts on output and prices were found to be relatively
modest in Belgium, France, the Netherlands, and Luxembourg and rela-
tively strong in Italy, Spain, Portugal, and Greece.
5.7 Conclusions
A consequence of the decentralized Eurosystem is that many of its
central banks have political weight that exceeds their economic weight.
While not necessarily a problem, this structure can introduce an unwel-
come bias into the ECBs decision making if country representatives
put some weight on national economic developments and these devel-
opments deviate notably from the behavior of euro area aggregates.
Although members of the ECB Governing Council do not act as
national representatives, but as fully independent persons, it is cer-
tainly possible that national economic welfare plays at least some role
in the (voting) behavior of regional representatives in the ECB Council.
Indeed, if national background should not play any role in the ECB
decision-making process, why then have the European governments
not delegated monetary policy fully to the Executive Board in the rst
place? The hypothesis of regional inuences in a federal central bank
system is supported by recent studies on US and German monetary
policy.
Table 5.15
Effects of 100 basis point rise in the policy interest according to models of national central
banks
Year 2001 2002 2003 2004 2005 2001 2002 2003 2004 2005
Consumption deator Real GDP
Belgium -0.10 -0.18 -0.21 -0.17 -0.12 -0.15 -0.20 -0.10 -0.05 -0.03
Germany -0.05 -0.19 -0.38 -0.56 -0.56 -0.28 -0.33 -0.09 0.15 0.26
Greece -0.16 -0.24 -0.29 -0.35 -0.38 -0.41 -0.78 -0.69 -0.72 -0.74
Spain -0.04 -0.25 -0.46 -0.68 -0.86 -0.12 -0.43 -0.62 -0.56 -0.39
France -0.07 -0.10 -0.12 -0.14 -0.16 -0.15 -0.28 -0.25 -0.16 -0.08
Ireland -0.09 -0.15 -0.15 -0.17 -0.22 -0.25 -0.48 -0.43 -0.38 -0.32
Italy -0.15 -0.33 -0.47 -0.50 -0.37 -0.26 -0.60 -0.55 -0.21 0.05
Luxembourg -0.02 -0.05 -0.06 -0.09 -0.13 -0.17 -0.25 -0.27 -0.23 -0.15
Netherlands -0.12 -0.20 -0.22 -0.30 -0.38 -0.20 -0.27 -0.25 -0.22 -0.16
Austria -0.10 -0.14 -0.14 -0.13 -0.12 -0.25 -0.47 -0.49 -0.36 -0.32
Portugal -0.07 -0.22 -0.26 -0.27 -0.35 -0.12 -0.56 -0.81 -0.74 -0.61
Finland -0.53 -0.50 -0.17 -0.02 -0.08 -0.34 -0.24 -0.15 -0.22 -0.25
Aggregate -0.09 -0.21 -0.31 -0.40 -0.40 -0.22 -0.38 -0.31 -0.14 -0.02
Euro area- -0.15 -0.30 -0.38 -0.49 -0.66 -0.34 -0.71 -0.71 -0.63 -0.57
wide model
Source: Van Els et al. (2001).
168 Chapter 5
There is quite some evidence that within the euro area, countries
diverge in terms of their business cycles, ination, andto a lesser
extentmonetary transmission. Our ndings cannot give a denite
answer to the question of whether business cycles will become more
or less synchronized under EMU. It is likely that EMU will further
intensify trade relations among the EMU countries, and this will lead
to more synchronization according to most studies. However, there is
also evidence indicating that monetary integration can lead to less syn-
chronization as the stabilizing inuence of exchange rate uctuations
is removed.
The evidence discussed in this chapter further suggests that ination
differentials within the euro area can be persistent. As far as the dif-
ferences in monetary transmission are concerned, it appears that
differences in the estimated impact of monetary policy on output
and prices across countries do not tend to be robust across different
methodologies, data, and models.
20
Although differences in transmis-
sion can be detected in individual studies, they are often not statisti-
cally signicant and moreover inconsistent across studies. Also the
connection between transmission differentials and differences in nan-
cial structure can be questioned. When it comes to the pass-through of
monetary policy measures to money market rates, there is evidence
suggesting at least some convergence.
What are the policy implications of the analysis? Our analysis seems
to lend some support to the view of euroskeptics as it appears that the
optimism on synchronization of business cyclesas, for instance,
expressed by Trichet (2001)is not fully warranted: there is only mixed
evidence that further integration will lead to more synchronization
of business cycles and ination differentials will not disappear.
The upcoming enlargement of the monetary union will probably only
increase economic divergence. In order to limit the risks of suboptimal
policies due to diverging economic developments, we advocate a more
centralized decision-making process within the ECB. In chapter 7 we
will return to the issue of ECB reform. However, next, in chapter 6, we
discuss the future enlargment of the Monetary Union.
6.1 Introduction
In this chapter we discuss the implications of the enlargement of the
European Union (EU) for EMU. The current members of the monetary
union will be joined by a number of new entrants that have substan-
tially lower incomes per capita. On May 1, 2004, ten countries joined
the European Union, and Bulgaria and Romania will become members
in 2007. The new EU countries are members of the EMU with a so-
called derogation. After a two-year waiting period, their convergence
will be evaluated based on the Maastricht criteria. At the earliest, the
new EU member states may therefore join the euro area in 2006 after a
positive assessment.
Several other countries, notably Slovenia and Estonia, are aiming to
join the euro area very soon after EU accession, and the incumbent
members of the monetary union are not likely to be able to do much
to keep the aspirants out.
In section 6.2 we assess the convergence achieved so far. Apart from
fullling the Maastricht criteria, the new member countries should
have an independent central bank before they can enter the monetary
union. Section 6.2 therefore starts with a review of the independence
of the central banks in the acceding countries. In the remainder of the
section we try to nd an answer to the question of whether a quick
entry into the monetary union is in the best interest of these countries
and, if so, which exchange rate will be optimal in the intermediate
period.
What are the implications of the entrance of new member countries?
Will the enlargement of EMU threaten the viability of the monetary
union? In other words, is enlargement of the monetary union in the
interest of its current members? Section 6.3 deals with these questions.
6
New Member Countries
170 Chapter 6
Similar considerations as those dealt with in chapter 5 (i.e., business
cycle synchronization, ination differentials, and nancial-structure-
related differences in monetary transmission) will be discussed. Section
6.4 offers our conclusions.
6.2 Central Bank Independence and Convergence
6.2.1 Central Bank Independence
Negotiations about EU membership started with the Czech Republic,
Cyprus, Estonia, Hungary, Poland, and Slovenia in March 1998, while
in February 2000 negotiations were opened with Bulgaria, Malta,
Latvia, Lithuania, Romania, and Slovakia. To qualify for membership
the applicants must have largely adapted their laws to comply with EU
legislation and have the ability to implement that legislation. This
implies that, before entry, the applicant countries should also have
implemented those aspects of the Economic and Monetary Union
acquis communautaire as dened by Title VII of the EC Treaty. This leg-
islation refers to the prohibition of direct public sector nancing by the
central bank, the prohibition of privileged access of the public sector to
nancial institutions, and independence of the national central bank.
In this section we discuss the recent literature on central bank inde-
pendence that relates to the new member countries. Most of this liter-
ature focuses on the transition countries; much less is known about
Malta and Cyprus.
As we saw in chapter 4, it is often argued that central bank inde-
pendence (CBI) is crucial for the credibility of monetary policy. Alarge
body of empirical research on industrialized countries has provided
evidence that a high degree of CBI is positively correlated with lower
average ination rates.
1
Many countries in transition delegated mone-
tary policy to a (legally) independent central bank. However, legal
independence is not enough, as stressed by Jean-Claude Trichet (2002),
at the time governor of the Banque de France, at the Munich Economic
Summit, June 8, 2002:
The effective implementation of the acquis communautaire is not only a legal pre-
requisite for accession to the EU. It also implies the effective transformation
of accession countries economic framework, which should facilitate their inte-
gration into the EU and, later, the euro area. In this context, it should be ensured
that there is no discrepancy between the central banks formal status in the leg-
islation and the implementation of that legislation. We consider that compre-
hensive concept as an essential contribution to the clarity and the credibility of
the single monetary policy. It is of utmost importance that all present and future
Member States respect this economic and institutional ground rule of the
European framework.
The main purpose of this section is therefore to analyze the degree of
legal CBI achieved by the new member countries and to analyze to
what extent it has been implemented.
In the literature, various denitions of CBI and proxies for CBI can
be found. The bottom line of indicators for CBI is that they all try to
measure how much inuence government has on monetary policy
making. Most indicators are based on central bank laws. Still the
criteria taken into account, the grading and weighting methods, and
the interpretation of laws differ widely across various studies. Conse-
quently it is no surprise that research on CBI comes up with sometimes
strikingly different results.
Most of the research on CBI refers to industrial countries. However,
the literature on legal and, to a lesser extent, actual CBI in countries in
transition has increased substantially in recent years. Simultaneously
various indexes of legal independence have been built.
2
Relevant con-
tributions are Cukierman et al. (2002), Hochreiter and Kowalski (2000),
Lybek (1999), Loungani and Sheets (1997), Radzyner and Riesinger
(1997), Malizewski (2000), and Dvorsky (2000).
Table 6.1 presents various indexes of legal CBI. Loungani and Sheets
(1997) derive two indexes of CBI: the rst covers the goal of economic
and political independence (CBI-DF), while the second assesses simi-
larity between the analyzed law and the statute of the Bundesbank
(SIB). Lybek (1999) has built an indicator for 15 former Soviet republics
consisting of 21 criteria, including most of the elements found in earlier
CBI indexes. Malizewski (2000) has constructed a slightly modied
version of the index of Grilli et al. (1991) for transition countries.
3
Similarly Cukierman et al. (2002) have calculated the values of the
independence index of Cukierman (1992) for the transition countries.
Also Dvorsky (2000) has calculated CBI for the CEEC-5 applying the
Cukierman index. The diverging results in table 6.1 illustrate that
the degree of CBI largely depends on the design of the index and the
criteria included.
It is remarkable that at least on paper most central banks in the new
member countries are independent. On average, aggregate legal inde-
pendence is substantially higher than in developed economies during
the 1980s (Cukierman et al. 2002). After the most recent central bank
New Member Countries 171
172 Chapter 6
reform (enacted in 1997), the central bank in Poland has, for instance,
a score of 0.89 on the Cukierman index compared to 0.69 for the
Bundesbank during the 1980s.
It has been widely acknowledged that, especially in developing
countries, legal indicators of CBI are often incomplete and noisy indi-
cators of actual CBI. Central bank legislation may not always be
implemented as initially intended for several reasons.
4
So there may be
substantial deviations between the law and actual practice (see also
sidebar 13). Furthermore the selection of criteria, the grading and the
weighting imply arbitrariness to a certain extent and are, therefore,
subject to discussion.
In response to these shortcomings of legal CBI indexes, Cukierman
(1992) and Cukierman et al. (1992) provide a different approach to mea-
suring CBI. Their proxy is based not on central bank laws but on the
actual average term in ofce of the central bank governor. This indica-
tor is based on the assumption that a higher turnover rate of the central
bank governor (TOR) reects a lower degree of CBI. The TOR is cal-
culated as follows:
Table 6.1
Legal central bank independence in (potential) new EU member states
Loungani-
Sheets
Cukierman
Country Dvorsky CBI-DF SIB Lybek Maliszewski et al.
Bulgaria NA 0.88 1.00 NA 15 0.55
Cyprus NA NA NA NA NA NA
Czech Republic 0.70 0.88 1.00 NA 13 0.73
Estonia NA 1.00 0.67 19 13 0.78
Hungary 0.75 0.31 0.72 NA 10 0.67
Latvia NA NA NA 15 12 0.49
Lithuania NA 0.13 0.33 18 15 0.78
Malta NA NA NA NA NA NA
Poland 0.90 0.50 0.61 NA 14 0.89
Romania NA 0.50 0.56 NA 7 0.34
Slovakia 0.69 NA NA NA 11 0.62
Slovenia 0.60 NA NA NA 11 0.63
Note: The index of Cukierman et al. (2002) is the most recent LVAW index after CB
reform and removal of the ruble.
13 CBI and the Rule of Law
Eijfnger and Stadhouders (2003) present an extension of the empirical
research on the relationship between CBI and ination. According to
these authors, legal arrangements are a prerequisite of CBI, but the trans-
lation of these legal arrangements into actual practice is of much greater
importance. Eijfnger and Stadhouders argue that the translation of legal
to actual CBI mainly depends on the rule of the law in a country. The
authors therefore introduce institutional quality indicators (IQIs) as
proxies for the rule of the law. These indicators are treated as a missing
link between legal and actual CBI. The idea behind this approach is that
if there is an interaction between legal CBI and IQIs, a measure for actual
CBI can be constructed using the IQIs as correction factor for legal CBI.
The outcome is a measure for effective CBI.
Eijfnger and Stadhouders construct proxies for actual CBI for both
developed and developing countries and test whether the institutional
environment is relevant to achieve price stability. They nd that the rule
of law and the institutional framework do matter in keeping ination
low, especially in countries in transition. Legal independence is a neces-
sary, but not sufcient, condition for actual CBI; it needs to be accompa-
nied by much liberalization. The peculiarities and characteristics of
transition economiesnarrow capital markets and limited access to
foreign nancing, large price shocks, and macroeconomic imbalances
undermine over ambitious institutional reform plans the same as they
do the rule of law. The effectiveness of CBI entails a high degree of
freedom to build up the central banks reputation.
Eijfnger and Stadhouders investigate effective CBI in transition
economies by using legal transition indicators (LTIs). These indicators
are provided by the European Bank for Reconstruction and Development
(EBRD) and are measures for the quality of the commercial legislation in
terms of two criteria: extensiveness and effectiveness of commercial law.
The overall legal transition indicator is signicantly and positively cor-
related with ination during early phases of transition. This result sug-
gests that during these phases the ambitious institutional reforms are
inefcient because macroeconomic imbalances and huge price shocks
raise the temptation to bend the law. When liberalization has reached a
sufciently high level, the legal transition indicator becomes signicantly
and negatively related to ination. The measure indicative of effective
CBI comes from multiplying the index of legal CBI (based on the LVAW
indicator of Cukierman et al. 2002) by the legal transition indicator.
174 Chapter 6
(6.1)
The idea behind this approach is that central bank governors who are
not as willing to follow government instructions will more often be dis-
missed than cooperative ones. Of course, it is possible that a low TOR
score is the result of a central bank governor being more compliant to
government, and who therefore remains longer in ofce than his rene-
gade colleagues. Another reason to cautiously regard this indicator is
that a governor who resigns could have done so for voluntarily, per-
sonal reasons.
The studies in which the TOR is used as a proxy for CBI generally
conclude that there is a signicant relationship between the TOR and
the inationary picture of developing countries. However, Sturm and
De Haan (2002) have extended the data set covering almost twice as
many countries as Cukierman (1992) and included information from
the 1990s. Their ndings are in sharp contrast to most of the previous
work, leading to the conclusion that in developing countries the
turnover rate of the TOR is often not related to ination. Likewise
Lybek (1999) failed to detect any connection between the number of
governors to the average annual ination and average annual growth
in the countries of the former Soviet Union for the period from 1992 to
September 1998. However, the period taken into account was probably
too short to obtain reliable results. Lybek also provided some anecdo-
TOR
Number of central bank governors
Length of actual term of ofce years or fractions of years
=
( )
.
Table 6.2
Legal transition (LTI) and effective CBI
LTI LVAW LVAW
*
LTI
Bulgaria 0.57 0.55 0.31
Czech Republic 0.86 0.73 0.63
Estonia 0.86 0.78 0.67
Hungary 0.86 0.67 0.58
Latvia 0.57 0.49 0.23
Poland 0.86 0.89 0.77
Romania 0.57 0.34 0.19
Slovak Republic 0.57 0.62 0.35
Slovenia 0.57 0.63 0.36
Source: Eijfnger and Stadhouders (2003).
tal evidence that some CB governors resigned before their term of-
cially expired due to increasing political pressure. Apparently some
governors stayed in ofce because they pursued an accommodating
monetary policy.
It is interesting to observe the degree of effective CBI in the
transition countries using the TOR as a proxy. The TOR can offer
valuable insight on the gap between legal and actual CBI (Cukierman
et al. 2002). Nevertheless, the short history of central banks in
transition countries should make one careful in drawing conclusions.
Any small shift in the base period can lead to big differences in the
TOR.
Radzyner and Riesinger (1997) have calculated the TOR for the
Czech Republic, Hungary, Poland, Slovenia, and the Slovak Republic.
They conclude that although all central banks covered enjoy a com-
paratively high degree of legal CBI, the actual term of ofce was sig-
nicantly shorter in some countries. The highest TOR is recorded in
Poland (see table 6.3). Dvorsky (2000) has updated the study of
Radzyner and Riesinger (1997).
5
Except for Slovakia, the countries
Table 6.3
Central bank independence in (potential) new EU member states: TOR
Legal term
Country Radzyner-Riesinger Dvorsky Lybek in ofce
a
Czech Republic 0.23 0.13 6
(12/923/97) (12/928/00)
Estonia 0.32 5
(1/929/98)
Hungary 0.38 0.23 6
(12/913/97) (12/918/00)
Latvia 0.16 6
(1/929/98)
Lithuania 0.62 5
(1/929/98)
Poland 0.49 0.35 6
(2/893/97) (2/898/00)
Slovakia 0.23 0.26 6
(11/923/97) (11/928/00)
Slovenia 0.17 0.11 6
(6/913/97) (6/918/00)
a. Source: Hochreiter and Kowalski (2000).
176 Chapter 6
monitored came up with a lower TOR compared to 1997, mainly
resulting from a longer base period and almost no personal changes at
the top of the central banks. The highest TOR is again registered for
Poland (0.35), which is quite interesting, since Poland has by far the
highest scores in terms of legal CBI. According to Dvorsky, the high
TOR is exclusively due to the frequent changes of governors from 1989
to 1992 and does not adequately reect the positive track record after
1992. Sidebar 14 provides some further discussion of the Polish case.
14 CBI in Practice: Poland
According to Radzyner and Riesinger (1997) and Dvorsky (2000), Poland
had a very high TOR. In terms of legal independence, the Polish central
bank is in the top ight of central banks and displays the highest scores
in applying various measures of legal CBI. This apparent paradox is,
however, quite easy to explain. The high score for the TOR in the refer-
ence period (19892000) is exclusively due to the frequent changes of
central bank governors in the very early stage of transition from 1989 to
1992.
The frequent changes from 1989 to 1992, however, turned out to be evi-
dence of the high political dependence of the National Bank of Polands
(NBP) at the time. Both Pakula and Baka resigned after the appointment
of a new government. Wojtowicz, the third governor was tripped by
a nancial scandal and served the shortest term in ofce. When
Gronkiewicz-Waltz was governor, a number of important central bank
law amendments were approved. In 1998 a new legal and institutional
framework for Polands central bank and the whole banking system was
adopted. The key issues taken into account were as follows (see NBP
1998):
The need to enhance CBI (with particular reference to monetary

policy).
The desire to foster the collective nature of the NBP management

process.
The European Treaty, which commits Poland to coordinate its domes-

tic legislation with EU law.
Gronkiewicz-Waltz shortened her second term of ofce to take up her
new position as vice president of the European Bank for Reconstruction
and Development (EBRD) in January 2001.
6.2.2 The Maastricht Criteria
EU membership does not imply immediate membership in EMU.
However, the new member countries will not get a similar position as
the United Kingdom and Denmark: they have an obligation to join
EMU. Before they can enter EMU, the new members have to fulll the
convergence criteria as stipulated by the Maastricht Treaty. These
include a two-year participation in the Exchange Rate Mechanism
Mark II (ERM II), without a devaluation of the parity rate against the
euro during this period. ERM II is solely open to EU member states,
and participation in this mechanism can thus begin only after acces-
sion to the European Union (see sidebar 15).
6
Whether and when the
new member countries satisfy the Maastricht criteria will be, to a sig-
nicant extent, at their discretion. Sweden has thus far evaded the
obligation to join EMU by not satisfying the exchange rate criterion
(Buiter and Grafe, 2002).
The Maastricht Treaty contains four convergence criteria:
1. Price stability. The average ination rate (measured on the basis of
the consumer price index) must not exceed by more than 1.5 percent-
age points that of, at most, the three best-performing member
countries.
2. Sustainable scal position. There can be no excessive decit. Excessive
decit exists if
the budget decit is higher than 3 percent of GDPunless either the

ratio has declined substantially and continuously and has reached a
level that comes close to 3 percent, or the excess over the 3 percent ref-
erence value is only exceptional and temporary and the decit remains
close to 3 percent;
the ratio of gross government debt to GDP exceeds 60 percent

unless the ratio is sufciently diminishing and approaching the refer-
ence value at a satisfactory pace.
Table 6.4
Central bank governors in Poland in chronological order
Zdzislaw Pakula July 1988 September 1989
Wladyslaw Baka September 1989 January 1991
Grzegorz Wojtowicz January 1991 August 1991
Hanna Gronkiewicz-Waltz March 1992 December 2000
Leszek Balcerowicz since January 2001
178 Chapter 6
15 ERM II
At its meeting in Amsterdam in June 1997, the European Council decided
to replace the Exchange Rate Mechanism (ERM) by a new ERM. The
Exchange Rate Mechanism Mark II (ERM II) offers an opportunity for EU
members that participate in the monetary union (the ins) as well as
members that do not (the outs) to stabilize their exchange rates. By the
Maastricht Treaty, each member state that is not yet allowed to partici-
pate in the euro area must treat its exchange rate policy as a matter of
common interest. In principle, this should also apply to the countries
with an opt-out clause, namely Denmark and the United Kingdom. Nev-
ertheless, membership of ERM II is voluntary for all outs.
The operating procedures for ERM II were laid down in an agreement
between the ECB and the national central banks of EU countries outside
the euro area. ERM II is designed as an asymmetrical, euro-centered
exchange rate system. The main feature of ERM II is the wide uctua-
tion of 15 percent between the euro and the currency of the country par-
ticipating in the mechanism. The bilateral central rate and the upper and
lower intervention rates (expressed as a percentage of the central rate)
are quoted using the euro as the base currency. Analogous to the old
mechanism is another important feature of ERM II. This is an automatic
and unlimited intervention at the margins by both the ECB and the par-
ticipating national central bank using the Very Short-term Financing
Facility. So the new mechanism involves a reciprocal commitment by
the ECB and respective central banks. It must be emphasized that these
credit lines are of a very temporary nature because the debt has to be
repaid within 75 days after the end of the month in which the interven-
tion took place. However, the ECB can suspend automatic intervention
if this conicts with its primary objective of maintaining price stability.
At the time of writing, the currencies in ERM II are the Danish krone,
the Estonion kroow, the Lithnanian litas, and the Slovenian tolar. Before
Greece joined EMU, the Greek drachma also participated in ERM II.
ERM II is compatible with a fairly broad range of exchange rate
arrangements. The Econ Council has only excluded three regimes: any
regime without a mutually agreed central rate to the euro, crawling pegs,
and pegs to currencies other than the euro. Entering the EU with a cur-
rency board where the currency is pegged to the euro is compatible with
ERM II, but the exchange rate target must be clearly viable, for instance,
because the system has been in operation for a substantial period.
A major challenge for entering ERM II will be nding a central rate
against the euro. To avoid the risk of misalignment, the central parity
should be as close as possible to the equilibrium exchange rate. There is,
however, a wide variety of methods and approaches to calculate equi-
librium exchange rates (see gert 2003 for an excellent survey).
3. Exchange rate stability. The currency must respect the normal uc-
tuation margins of the Exchange Rate Mechanism Mark II (ERM II),
without severe tensions for at least two years (especially no devalua-
tion on the initiative of the member country concerned).
4. Low interest rate. The average long-term interest rate must not exceed
by more than 2 percentage points the interest rates in, at most, the three
best-performing countries in terms of price stability.
Although these criteria have been criticized for their lack of theoretical
foundation (e.g., see Eijfnger and De Haan 2000), the member coun-
tries of the European Union have made it clear that the new member
countries must stick to this part of what is called the acquis cummu-
nautaire. The Maastricht convergence criteria cannot be changed for
new members, and the criteria must be applied in the same manner as
in the convergence examinations so far. This is to ensure equal treat-
ment between future Member States and the current participants in the
euro area (Econ 2000).
One of the most critical issues seems to be the fullment of
the budget decit criterion, as various new member countries at the
time of writing record major scal imbalances. The Czech Republic,
Hungary, Poland, and Slovakia had budget decits ranging from more
than 4 percent to 8.5 percent of GDP in 2002 (Back and Wjcik 2003).
Another important issue is the choice of the proper exchange rate
regime for the new member countries in the period between entering
the European Union and becoming a (full) member of the Monetary
Union. The exchange rate regime is a key determinant of a countrys
macroeconomic stability, which affects the investment climate. Apart
from the perspective of future EMU membership, the choice of ex-
change rate regime is therefore of great relevance for the new member
Wyplosz (2003b) argues that ERM I could survive for a decade thanks
to the widespread presence (in the countries with a weak currency) of
capital controls. When these controls were eliminated, ERM I became
unstable. According to Eichengreen and Wyplosz (1993), some of the
speculative attacks on currencies participating in ERM I were not related
to fundamentals. The new members are committed to repeal all capital
controls upon EU accession. According to Wyplosz, this means that ERM
II will become structurally unstable, possibly even with the wide 15
percent margins.
180 Chapter 6
countries. Table 6.5 shows the exchange rate regimes of the (potential)
new EU members in 2003.
An important consideration in choosing an exchange rate regime is
that the new members have to liberalize international capital ows as
part of the acquis communautaire, making them more vulnerable to spec-
ulative attacks. As Wyplosz (2003b) argues: The repeated worldwide
experience is that, almost unavoidably, disappointments of one kind or
another (economic, political, international) eventually arise and trigger
speculative reversals of capital ows. EU accession will reinforce this
phenomenon, while the mandatory repeal of capital controls will
magnify the size of capital movements in either direction. . . . Capital
inows and outows stand to rock the exchange rate and to trigger
unmanageable speculative attacks.
As follows from table 6.5, a number of countries currently have a cur-
rency board. Acurrency board can be considered the most credible form
of a xed exchange rate regime. It ensures that the own currency is con-
vertible against a xed exchange rate with some other currency(ies)
that is codied, be it in a law or otherwise. The anchor currency is gen-
erally chosen for its expected stability and international acceptability.
There is, as a rule, no independent monetary policy as the monetary
base is backed by foreign reserves.
Acurrency board is a strong, double-barreled commitment device
(Buiter and Grafe 2002). Through the currency peg it represents a com-
Table 6.5
Exchange rate regimes of (potential) new EU member states, 2003
Country Exchange rate regime
Bulgaria Fixed peg to euro (currency board)
Cyprus Fixed peg to euro with de facto band 12%
Czech Republic Free oat (ination targeting)
Estonia
a
Fixed peg to euro (currency board)
Hungary Crawling peg to euro with band 15% (implicit ination targeting)
Latvia Fixed peg to SDR (quasi-currency board)
Lithuania
a
Fixed peg to euro (currency board)
Malta Peg to weighted basket of euro, USD, GBP (0.25% band)
Poland Free oat (ination targeting)
Romania Managed oat
Slovakia Managed oat
Slovenia
a
Managed oat
Source: EEAG (2004).
a. Participates in ERM II since June 2004.
mitment to price stability. Through the no domestic credit expansion
constraint, it represents a commitment to budgetary restraint. The
value of these commitments depends either on the currency board
arrangement being perceived as credible and permanent or on the
belief that, if it is abandoned, it will be replaced by something repre-
senting a comparable commitment to price stability and budgetary
responsibility as a credible currency board, like the EMU.
At the other extreme, a country may choose a oating exchange
rate regime with an independent central bank with some kind of an
ination-targeting strategy. Berger et al. (2001b) show that a currency
board becomes, ceteris parifus, more attractive under the following
conditions:
The imported foreign monetary policy is in the hands of an inde-

pendent and conservative (i.e., ination-averse) foreign central bank.
The home countrys central bank is relatively dependent and output-

oriented compared to the foreign central bank.
The correlation between the home and foreign countrys output

shocks is high.
Compared to a full-edged central bank, a currency board is a cheap
way of managing monetary policy. As pointed out by Buiter and Grafe
(2002), all that is needed is a sufcient number of modestly skilled bank
clerks who exchange, at a xed rate, domestic currency for the foreign
currency in terms of which the peg is dened. As a currency board
implies that the central bank cannot (fully) act as lender of last resort,
no country should consider a currency board unless it can afford to do
without a lender of last resort. As this safety net for the nancial sector
is missing, a prerequisite for a currency board is a reasonably healthy
nancial system. Likewise no country should consider a currency
board unless it has a sound scal framework that will not require dis-
cretionary access to central bank nancing by the general government.
Acurrency board runs the risk of a real misalignment. If a countrys
ination remains higher than that of the pegging country, the currency
can become overvalued (Pautola and Back 1998). While xing the
exchange rate is a fast way to disinate an economy starting with a
higher ination rate, pegging the exchange rate will not necessarily
reduce the ination rate instantaneously to that of the pegging
country. There are several reasons why ination will not fall right away
(Roubini 1999). First, purchasing power parity does not hold exactly in
182 Chapter 6
the short run, since domestic and foreign goods are not perfectly sub-
stitutable and the mix of goods and services in the countries concerned
may differ. Second, nontradable goods prices do not feel the same com-
petitive pressures as tradable goods prices, so ination in the non-
traded sector may fall only slowly. Third, there is signicant inertia in
nominal wage growth. Often wage contracts are backward looking and
the adjustment of wages occurs slowly. Finally, differing productivity
growth rates may be reected in differences in price increases (Balassa-
Samuelson effect; see section 6.3.2). If domestic ination does not con-
verge to the level of the pegging country, a real appreciation will occur
over time. As Roubini (1999) points out, such a real exchange rate
appreciation may cause a loss of competitiveness and a structural wors-
ening of the trade balance, which makes the current account decit less
sustainable.
As we pointed out above, according to many observers, speculative
attacks are a huge risk in the run-up to membership of the monetary
union. To what extent are currency boards less vunerable than other
exchange rate systems to specultative attacks? Although it is sometimes
claimed that speculative attacks cannot occur under currency boards,
recent experience has shown otherwise. Still, existing evidence sug-
gests that xed exchange rate regimes are more likely to survive than
pegs with more exibility (Frankel, 1999).
Buiter and Grafe (2002) argue that from an economic point of view,
a currency board with the euro can make sense for the new member
countries. A country with a currency board would have a natural
strong exit in the form of EMU membership. Furthermore they have
restructured their banking sectors, so that the lack of a lender of last
resort may not be problematic. Monetary independence through a
oating exchange rate permits exibility (the valuable ability to
respond to shocks), but the downside of this exibility is the risk of
opportunistic policies. According to Buiter and Grafe (2002), the
benets of monetary independence in most new member countries
should not be overstated. They argue that monetary policy in these
countries is particularly unlikely to be very effective in stabilizing
output because credit, deposit, and debt markets are still rather under-
developed. Consequently changes in the cost and availability of
domestic credit are unlikely to have a large immediate effect on output,
either through the interest rate or through the credit channel. In mon-
etary and nancial systems undergoing rapid transformations the
monetary transmission mechanisms are both poorly understood and
quite unstable, which increases the likelihood that central banks in the
region may miss the announced ination targets. Finally, as we have
shown above, the strength of the political commitment to central bank
independence remains questionable in some new member states. Even
if no further challenges to central bank independence occur, it will take
time for markets to become assured of the independence of the central
banks.
It follows from the preceding analysis that a currency board with a
peg to the euro may be the proper exchange rate regime for the new
member countries on their road to full EMU membership. Apart from
the (related) risk of misalignment, there may, however, be a serious
problem. Together, the exchange rate and the ination criterion restrict
the scope for changes in the real exchange rate of the new member
countries vis--vis the euro. Due to the Balassa-Samuelson effect, these
countries may experience higher ination than the euro area in case of
a nominal xed exchange rate. This has led Szapary (2000) and Buiter
and Grafe (2002) to argue that the ination criterion of the Maastricht
Treaty should be relaxed or reinterpreted.
7
To examine whether this
conclusion is justied, in section 6.3.2 we will discuss the literature on
the Balassa-Samuelson effect in the transition countries. However, rst
we must consider the optimal currency area (OCA) literature, as it is
relevant to our discussion on the entrance of the new member coun-
tries to the monetary union.
6.2.3 Optimal Currency Area Considerations
It is well known from the OCA literature that the Maastricht conver-
gence criteria do not help a country decide whetherfrom an economic
perspectiveit should join a currency union (e.g., see Eijfnger and
De Haan 2000). OCA theory suggests that the answer should depend
on the balance of benets and costs, whether it is benecial for a
country to join a monetary union. In essence, by OCAtheory, countries
exposed to symmetric shocks or possessing mechanisms for the absorb-
tion of asymmetric shocks should nd it optimal to use a common
currency.
The benets of monetary union include lower transaction costs,
reduction of exchange rate volatility and uncertainty, more price trans-
parency, and a better functioning internal market. The costs of a mon-
etary union mainly derive from the loss of an instrument of economic
policy, meaning the exchange rate. In a monetary union the participat-
ing countries no longer can change the price of their own currency
184 Chapter 6
vis--vis other currencies. How serious this loss is depends on three
factors: the need for exchange rate adjustments, the effectiveness of
exchange rate adjustments, and the availability of other instruments.
The need for exchange rate adjustments depends on the importance
and character of economic shocks. Country-specic shocks only strike
one country, in contrast to general shocks, which strike all countries.
Shocks that strike a single country are, by denition, asymmetric.
However, general shocks can also have an asymmetric impact, depend-
ing on the structural characteristics of the economies being struck. For
instance, an oil price hike affects oil-importing countries differently
than oil-exporting countries. Also the nature of the shock matters. As
pointed out by Borghijs and Kuijs (2004), exible exchange rates can
generate rapid adjustment in international relative prices even where
domestic prices adjust slowly. This makes them potentially useful
absorbers of real shocks, which require an adjustment in relative prices
in order to switch expenditure. For instance, a sudden drop in
demand will, under exible exchange rates, cause a depreciation, that
crowds in extra demand. However, exchange rate adjustment in
response to monetary and nancial shocks leads to undesired changes
in relative prices. For instance, a negative nancial shock putting
upward pressure on interest rates will cause the exchange rate to appre-
ciate, so it acts to amplify rather than dampen the negative impact on
output. The more important asymmetric real shocks are, the higher are
the costs of relinquishing the exchange rate instrument.
Whether an exchange rate adjustment will help to adjust a country
to an asymmetric shock depends on the pass-through to import prices
(Borghijs and Kuijs 2004). If changes in the exchange rate do not gen-
erate an adjustment in international relative prices because pass-
through to import prices is very small, the exchange rate is of little
use as a shock absorber even in the case of asymmetric real shocks.
According to Obstfeld (2002), empirical evidence to date suggests that
exchange rate changes affect relative prices.
Finally, alternative adjustment mechanismslike labor mobility,
price and wage exibility, and scal policycan, in principle, solve the
adjustment problem after the occurrence of an asymmetric shock. The
stronger these alternative adjustment mechanisms are, the less costly it
will be to give up monetary sovereignity.
The following characteristics have been argued on the basis of the
OCA theory to favor retention of the national currency, and the asso-
ciated scope for nominal exchange rate exibility (Buiter 1999b):
1. High nominal rigidity in domestic prices and/or costs. If wages and
prices are exible, adjustment after an asymmetric shock will be
smooth and quick, so there is no need to use the exchange rate instru-
ment to counter shocks.
2. Relatively low openness to trade in real goods and services. The
more open an economy is, the more likely it is that domestic nominal
costs, including wages and prices, will be strongly linked to the
exchange rate.
3. High incidence of asymmetric (nation-specic) shocks rather than
symmetric or common shocks and/or dissimilarities in national eco-
nomic structures or transmission mechanisms that cause even sym-
metric shocks to have asymmetric consequences. As explained above,
low asymmetry can call for a common currency.
4. Less diversied structure of production and demand. If a country
has a well-diversied structure of production and demand, it is less
likely to experience asymmetric shocks.
5. Low degree of real factor mobility (especially labor mobility) across
national boundaries. As pointed out above, factor mobility is an
alternative adjustment mechanism to asymmetric shocks. So a high
factor mobility makes it less costly to give up the exchange rate
instrument.
6. Absence of signicant international (and supranational) scal
taxtransfer mechanisms. A scal transfer system may act as an alter-
native adjustment mechanism. The country suffering an asymmetric
shock will receive support in one way or another. For instance, in the
US system states receive more funds from the federal budget when they
are experiencing low rates of growth. So such a system makes it advan-
tageous to enter a monetary union even if asymmetric shocks occur
frequently.
These criteria are sometimes used to argue that the new member
countries should not aim for a quick entry into the monetary union.
What is the evidence to date?
Little is know about wage exibility in the new member countries.
The only empirical multiple-country studies that we are aware of are
Blanchower (2001) and Iara and Traistaru (2003).
8
These studies esti-
mate so-called wage curve models that relate wage levels to local
unemployment rates. The stronger the responsiveness of wages to
unemployment, the more exible wages are. Blanchower (2001)
186 Chapter 6
estimates wage curves for fteen transition countries, including nine
new EU members, using both individual micro data and aggregate
regional data sets. He nds unemployment elasticities of pay ranging
from -0.021 for the Czech Republic to -0.462 for Latvia (in regressions
without xed effects, and -0.096 (GDR) to -0.520 (Latvia) in regressions
with xed effects.
9
Iara and Traistaru (2003) investigate the respon-
siveness of regional average earnings to local labour market conditions
in Bulgaria, Hungary, Poland, and Romania. They nd empirical
support for the wage curve in Bulgaria, Hungary, and Poland. At -0.12,
unemployment elasticity of pay in Bulgaria is highest and close to that
found in advanced economies (-0.10). Hungarian and Polish elastici-
ties, -0.05 and -0.04 respectively, are only half of that.
Table 6.6, based on Van de Coevering (2003), presents some other
OCAindicators. The rst indicator refers to convergence in production
structures. Krugman (1993) developed an output divergence index to
measure the degree of specialization in any given country compared to
another country or group of countries. The index is the sum of the
absolute differences in share between the given country and the bench-
mark in a number of economic sectors. The production structure of
each country is compared to the euro area as a whole for six different
sectors. It follows that considerable differences exist among the pro-
duction structures of the countries considered. All new member coun-
tries display a considerably higher index than the average of the euro
area countries.
The next columns of table 6.6 refer to openness (to the world and the
euro area), measured as half the ratio of exports plus imports over GDP.
Because annual trade data uctuate considerably, three-year averages
were used in calculating openness. In addition the share of intra-
industry trade in total trademeasured by the so-called Grubel-Lloyd
index
10
is shown. If the index is 0, all exports and imports are in dif-
ferent types of goods. In that case countries are fully specialized and
all trade is interindustry. Avalue of 100 means that imports and exports
are of the same size in all types of goods so that all trade is intra-
industry.
All new member countries have strong trade relationships with the
euro area. Hungary, Estonia, Slovenia, the Czech and Slovak Republics,
trade even more with the euro area than any of the current euro area
members, with the exception of Belgium/Luxembourg. Only Latvia,
Lithuania, Poland, and Romania are less open than the average of euro
area countries.
Table 6.6
OCA Indicators: Euro area countries and new member countries
Output Grubel-Lloyd
divergence index with
index Openness 19992001 EU15
1995 2001 World Euro area 1993 2000
Austria 11 11 33 20 77
d
82
Belgium 6 8 68
c
42 81 85
Finland 15 18 29 10 56
d
57
France 10 7 22 12 86 88
Germany 9 9 25 11 77 77
Greece 27 33 16 8 27 26
Ireland NA NA 60 18 60 56
Italy 11 9 19 9 65 73
Luxembourg 31 33 NA NA NA 67
Netherlands 8 9 52 28 74 72
Portugal 15 11 26 18 47 61
Spain 19 18 20 11 69 87
Average euro area 15
a
15
a
35 17 65 68
Bulgaria NA NA 41 19 46 39
Czech Republic 33 38 58 35 58 74
Estonia 27 33 67 28 17 57
Hungary 16 21 60 37 57 75
Latvia 40 40 36 13 13 20
Lithuania 41 43 41 13 15 37
Poland 40 46 25 14 45 58
Romania 60 57
b
30 17 30 41
Slovak Republic 34 34 64 33 42 68
Slovenia 25 24 50 31 61 71
Source: Van de Coevering (2003).
a. Excluding Ireland.
b. Data for 2000.
c. Plus Luxembourg.
d. Data for 1996.
188 Chapter 6
Both the euro area and the CEE countries show considerable hetero-
geneity with respect to the level of intra-industry trade in total trade.
During the 1990s most new member countries showed substan-
tial increase in their intra-industry trade. Still there are important
differences among these countries. Hungary, the Czech and Slovak
Republics, and Slovenia, even surpassed the euro area average in intra-
industry trade, while some other countries showed only moderate
growth of intra-industry trade.
Jan Fidrmuc (2001) assesses the efcacy of interregional migration
as a channel of regional adjustment in the Czech Republic, Hungary,
Poland, Slovakia, and Lithuania. The analysis relates gross and net
migration ows scaled by the regions population to regional un-
employment rates and average wages. The main nding is that the
efcacy of labor mobility as a channel of regional adjustment
to idiosyncratic shocks has been rather limited in the transition
economies. Regions with high wages tend to display both high immi-
gration and emigration. The response of net migration ows to regional
economic conditions is economically small, and migration ows have
been declining since the onset of transition.
In our view, the OCA criteria do not unambiguously suggest that it
may be better for the new member countries to wait before they enter
the monetary union. The data show that considerable structural diver-
gence within the euro area exist. So, if the current euro area is consid-
ered optimal for all countries involved, there is no reason for most of
the new member countries to postpone entry.
Furthermore OCA theory has recently been severely criticized,
mostly on three grounds (Back and Wjcik 2003). First, the OCA cri-
teria are endogenous. As argued by Frankel and Rose (1998), joining a
currency union will eliminate exchange rate uncertainty and reduce
currency transaction costs, which will stimulate bilateral trade. This in
turn will foster business cycle synchronization and reduce the expo-
sure to asymmetric real shocks, which will validate (ex post) the adop-
tion of the common currency (see also section 5.4). Rose (2000) nds
that the trade effects of using a common currency are huge: countries
with a common currency trade over three times as much as countries
using different currencies. Similar results are reported by Rose and van
Wincoop (2001). Frankel and Rose (2002) also nd large potential ben-
ets from the use of a common currency in trade and also that the addi-
tional trade has substantial positive effects on growth. Other studies,
for instance, those by Melitz (2001) and Persson (2001) arrive at con-
siderably lower benets.
11
Some studies explicitly focus on the trade-enhancing effects of the
introduction of the euro. Micco et al. (2003) nd that the effect of EMU
on bilateral trade between member countries ranges between 4 and 10
percent, when compared to trade between all other pairs of countries,
and between 8 and 16 percent, when compared to trade among non-
EMU countries. Bun and Klaassen (2002), using a dynamic panel model
for annual bilateral exports, nd that the euro has signicantly in-
creased trade, with an effect of 4 percent in the rst year and cumulat-
ing to around 40 percent in the long-run. Table 6.7 summarizes these
and other studies.
Clearly, the literature suggests that EU membership can lead to busi-
ness cycles that bring new members in sync with those of the euro area.
Fidrmuc (2001) computed the potential correlation to the business
cycle in Germany for ve new member countries (the Czech Republic,
Hungary, Poland, Slovenia, and the Slovak Republic) using Frankel
and Roses (1998) relation between the degree of trade intensity
and similarity of business cycles. His predicted correlations for the
Czech Republic, Pland, and Hungary average around 0.35, while the
correlations for Slovenia and the Slovak Republic average around 0.24,
since their trade is less oriented toward Germany.
12
The issue of busi-
ness cycle synchronization of the new member countries and the
current euro area countries will be discussed in more detail in section
6.3.1.
Table 6.7
Studies on the trade-enhancing effect of the euro
Study g Standard error of g
Micco et al. (2003) 0.089 0.025
Bun and Klaassen (2002) 0.33 0.10
De Souza (2002) 0.17 0.24
Flam and Nordstrm (2003) 0.139 0.02
Barr et al. (2003) 0.25 0.033
De Nardis and Vicarelli (2003) 0.061 0.027
Source: Rose (2004).
Note: Reported are the estimated impact (g) of a common currency on bilateral trade
intensity and the standard error. The reported gures are the most preferred or repre-
sentative estimates according to Rose (2004).
190 Chapter 6
Second, risk-sharing arguments support the view that under full
nancial market integration, countries exposed to asymmetric shocks
can prot from monetary unication. A common currency is seen to
facilitate portfolio diversication, which allows countries to adjust more
smoothly and at lower costs to asymmetric real shocks (Mlitz and
Zumer 1999). For a country experiencing an adverse country-specic
shock, its foreign assets holdings can smooth the income effect of the
adverse shock.
Third, the exchange rate can be seen as a source of shocks rather than a
shock absorber, in particular for small open economies (e.g., see Artis
and Ehrmann 2000). As Buiter (1999b) put it, a fatal aw in the OCA
literature is its failure to allow properly for the international mobility
of nancial capital. This has led to an overemphasis on the stabilising,
buffer stock potential of a market-determined nominal exchange rate,
and a failure to recognise its destabilising potential. I view exchange
rate exibility as a source of shocks and instability as well as (or even
rather than) a mechanism for responding effectively to fundamental
shocks originating elsewhere. Similarly Borghijs and Kuijs (2004) nd
for the Czech Republic, Hungary, Poland, the Slovak Republic, and
Slovenia that on the basis of a Clarida and Gali-type structural VAR, in
these countries the exchange rate served more as an unhelpful propa-
gator of monetary and nancial shocks than as a useful absorber of real
shocks.
Finally, many new member countries already use the euro (or the
dollar) for transaction purposes even though they have not ofcially
adopted the euro. Table 6.8 shows some estimates of unofcial euroiza-
tion (dollarization).
In conclusion, we believe that a costbenet assessment of the choice
between a quick entry and waiting denitely favors the earliest-
possible strategy than that of waiting (see also Thygesen 2002). Bud-
getary consolidation is much easier to accomplish with the help of the
lower interest rate resulting from a clear perspective of entering the
monetary union. Furthermore the risks of exchange rate instability
become lower as the waiting period becomes shorter. For new member
countries with a currency board that have already shown for a number
of years that they can live with a unilaterally xed exchange rate, it is
in any case difcult to advocate waiting. There appears to be no com-
pelling reason for persuading these member countries to give up their
currency boards during the two-year waiting period as dened in the
Treaty.
N
e
w

M
e
m
b
e
r

C
o
u
n
t
r
i
e
s
1
9
1
Table 6.8
Euroiazation and dollarization in new member countries
Feige (2003) De Nicolo et al. (2003)
FCC/TCC in 2001 FCD/M2 Years FCD/M2 Years FCD/total dependence Years
Bulgaria 0.41** 0.392 19912001 0.324 19901999 0.417 199399
Czech Republic 0.21* 0.111 19932001 0.09 19932000 0.102 19932000
Estonia 0.59** 0.172 19932001 0.132 19922000 0.184 19952000
Hungary 0.06* 0.163 19902001 0.128 199099(excluding 1996) 0.063 199799
Latvia 0.79** 0.3 19932001 0.286 199395 0.0185 199697
Lithuania 0.11** 0.329 19932001 0.291 19932000 0.423 19932000
Poland 0.27** 0.156 19902001 0.199 199099 0.178 199499
Romania 0.55** 0.428 19902001 0.234 19902000 0.283 19902000
Slovakia 0.28* 0.156 19972001 0.126 19932000 0.141 19932000
Slovenia 0.54* 0.353 19972001
Note: FCC = foreign currency in circulation; TCC = total currency in circulation; FCD = foreign currency deposits.
* = dollar and holdings of European legacy currencies (AST, DM, and SF); ** = dollar holdings only.
192 Chapter 6
So, from the perspective of the new member countries, a quick entry
in the euro area would be a sensible strategy. But what about the con-
sequences of an enlargement of the monetary union for countries that
are currently in the euro area? This issue is the subject of the next
section.
6.3 Implications of Enlargement of the Monetary Union
6.3.1 Business Cycle Synchronization
Eichengreen and Ghironi (2001) use a model from the empirical growth
literature, estimated on data for the 1980s and 1990s, to forecast growth
rates in an enlarged EMU in the subsequent period. Their results are
reproduced in table 6.9. The admission of new members is expected
to increase the dispersion of growth rates within EMU considerably.
However, Eichengreen and Ghironi (2001) conclude that growth-rate
variability will not be greatly aggravated by enlargement to include the
members of the 1998 Accession Groupthe Czech Republic, Estonia,
Hungary, Poland, and Slovenia. The expansion of the monetary union
to include the 1998 Accession Group should therefore be relatively
easily accommodated, while expansion to include the 2000 Accession
Group (Bulgaria, Latvia, Lithuania, Romania, and Slovakia) will pose
a much more serious challenge for EMU. Eichengreen and Ghironi
(2001) also argue that if institutions are quickly upgraded to EU levels,
the dispersion of growth rates will fall, even in the short run, reducing
the strains on monetary policy. In reaching this conclusion, they use a
measure of institutional quality based on indicators for voice and
accountability (a measure of political and civil freedom), political sta-
bility, government effectiveness, adequacy of the regulatory frame-
work, rule of law, and corruption control.
Table 6.9
Standard deviations of growth rates in an enlarged EMU
No institutional reform Institutional convergence
Current EMU members in 1999 1.80
Current EMU members in 2006 0.79
All EU members in 2006 1.39
Plus 1998 accession group 1.41 1.29
Plus 2000 accession group 2.10 1.18
Source: Eichengreen and Ghironi (2001).
Other authors reach less optimistic conclusions. For example, Berger
et al. (2004) argue that the correlation between the cyclical components
of industrial production in the various (potential) new member states
and the cyclical part of industrial production in the euro area is quite
low.
13
Table 6.10 is reproduced from their study. Industrial production
is decomposed into a trend and a cyclical component, using a Hodrick-
Prescott lter. It follows that except for Slovenia and, to a lesser extent,
Cyprus, the new member countries have business cycles that are hardly
synchronized with the business cycle in the euro area. The same holds
true for some other euro area countries, notably Greece and Portugal.
Furthermore, as pointed out by Fidrmuc (2001), at the beginning of the
1990s the transition countries were in a transitional recession. Fidrmuc
(2001) has calculated the correlation of business cycles in ve accession
countries and of Germany for the period 1993 to 1999 and nds that
the business cycle synchronization of most of these countries was very
similar to that of current euro area countries.
The Autumn 2003 Report of the European Forecasting Network (EFN
2003) contains an analysis of business cycle similarities of the new
member countries and the euro area. Table 6.11 is reproduced from this
report. It shows some cyclical characteristics of the deviation cycles
Table 6.10
Business cycle correlation (with EU12) for the period, 19902001
Old EU members New EU members
Austria 0.49 Bulgaria NA
Belgium 0.36 Cyprus 0.32
Finland 0.36 Czech Republic 0.11
France 0.76 Estonia 0.11
Germany 0.75 Hungary 0.20
Greece 0.18 Latvia 0.17
Ireland 0.26 Lithuania -0.17
Italy 0.62 Malta NA
Luxembourg 0.38 Poland 0.17
Netherlands 0.33 Romania -0.04
Portugal 0.06 Slovakia 0.12
Spain 0.71 Slovenia 0.65
Denmark 0.52
Sweden 0.36
United Kingdom 0.31
Source: Berger et al. (2004).
194 Chapter 6
extracted from the monthly indexes of industrial production from 1993:
1 onward. The deviation cycle (where the turning points are
characterized by changes relative to trend) is determined by applying
a band-pass lter based on two low-pass Hodrick-Prescott lters.
Subsequently dating rules (which incorporate minimum phase and
cycle duration restrictions) are applied along the lines of Artis et al.
(2002).
It follows from table 6.11 that the average proportion of time spent
in expansion hovers around the theoretical benchmark of 0.5. The
average length of a recession in the new member countries is very
similar to the euro area average, although there is quite some variation
among the new members. The strongest difference is the output loss;
the amplitude of a business cycle in the new member countries is gen-
erally greater than in the euro area. Also the steepness of recessions is
greater in these countries. The nal column of table 6.11 shows the busi-
ness cycle correlation with the euro area. It follows that Hungary,
Poland, and Slovenia have high correlation coefcients, while the busi-
ness cycles in Latvia and Lithuania seem to be very much out of sync
with the euro area cycle. For some countries, notably Hungary and
Poland, the correlations are somewhat higher than those reported in
table 6.10, which probably reects differences in time periods consid-
ered. Spel (2003) also nds that Hungary and Poland have the
Table 6.11
Business cycle properties in new member countries (deviation cycles based on industrial
production)
Proportion Average Correlation
of time in duration Output loss with euro
expansion recession (%) Steepness area
Czech Republic 0.42 31.3 3.36 0.11 0.16
Estonia 0.44 27.0 12.65 0.47 0.40
Hungary 0.52 29.0 11.03 0.38 0.91
Latvia 0.50 20.0 8.00 0.40 -0.02
Lithuania 0.54 19.0 11.98 0.63 -0.04
Poland 0.43 17.3 3.88 0.22 0.67
Slovakia 0.43 17.0 5.11 0.30 0.32
Slovenia 0.53 19.0 4.63 0.24 0.65
Average 0.45 22.4 7.58 0.34
Euro area 0.43 22.7 4.52 0.20
Source: EFN (2003).
strongest correlation with the euro area, both in terms of cycles in GDP
and industrial production. EFN (2003) further shows the pattern of
the business cycle synchronization over time. It reveals that Hungary,
Poland, and Slovenia see their business cycle getting closer to the euro
area cycle, while the Czech Republic and Slovakia move away from the
euro area; the Baltic countries share similar tendencies, but they have
been in the past less correlated with the euro area.
Darvas and Szapry (2004) also analyze the synchronization of busi-
ness cycles between the euro area and the new member countries.
In contrast to previous studies, these authors also focus on the major
expenditure and sectoral components of GDP, using several measures
of synchronization. Like EFN (2003), they nd that Hungary, Poland,
and Slovenia have achieved a high degree of synchronization with the
euro area. This conclusion holds for GDP, industrial production, and
exports, but not for consumption and services. The other new member
countries have achieved less or no synchronization. Hungary, Poland,
and Slovenia show strong improvement in cyclical correlation from
1993 to 1997 to 1998 to 2002. However, the other ve countries consid-
ered show almost no tendency to move toward greater synchroniza-
tion during this period. In all the new member countries there is
minimal or even negative correlation with the euro area cycle of private
consumption and also of services.
Most papers discussed so far use industrial production for con-
structing business cycles, given the availability of high-frequency data
for this variable. However, as pointed out by Spel (2003), industry
data can overstate the co-movements of the overall economies, a
nding also supported by Darvas and Szapry (2004). Spel has there-
fore constructed a broad cycle factor, using three separate indicators for
each country: annual growth of industrial production, annual growth
of retail sales volumes, and annual growth of construction output. The
joined cyclical component has been estimated by using a state space
model. He nds that the average correlation of the cyclical component
of this broad indicator in the new member countries with that of the
euro area is close to zero. This should act as a clear warning: conclu-
sions concerning synchronization of business cycles that are based on
industrial production can be too optimistic.
Business cycles can differ across nations or regions within a nation
for various reasons. First, nations and regions can experience different
shocks. Second, they may respond differently to common shocks. This
may be due to differences in the reaction of policy makers to a common
196 Chapter 6
shock or to differences in the national or regional composition of
output. Also differences in nancial and economic structure can lead
to differences in the monetary policy transmission mechanism.
Figure 6.1 displays the correlation of demand shocks (y-axis) and
supply shocks (x-axis) in quarterly real GDP for individual euro area
and new member countries with demand and supply shocks in the
euro area aggregate computed by Fidrmuc and Korhonen (2003). This
approach follows that suggested in the seminal paper by Bayoumi and
Eichengreen (1993). The sample period is 199192 to 2000 for most
countries. Shocks are identied using two-variable VARs for output
and prices and the Blanchard and Quah (1989) assumptions. Despite
considerable variance within groups, the results indicate that, on
average, demand and supply shocks are more closely correlated in
todays euro area. Most euro area countries are located in the upper-
right part of the gure, while most candidate countries nd themselves
in the lower-left, indicating nonsignicant or even negative coefcients
of correlation.
14
Notable exceptions from the rule are two of the more
advanced countries among the candidate countries, Estonia and
Hungary, which rank among the euro area countries. The correlation
of shocks in Greece, which entered the euro area late and is thus early
in its real convergence process, and in Ireland, which was among the
BGR
CZE
EST
HUN
LVA LTU
POL
ROM
SVK
SVN
AUS
BEL
FIN
FRA
GER
GRC
IRL
ITA
LUX
NLD
PRT
ESP
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
-0.2 0.0 0.2 0.4 0.6 0.8
Supply shocks correlation
D
e
m
a
n
d

s
h
o
c
k
s

c
o
r
r
e
l
a
t
i
o
n

Figure 6.1
Demand and supply shocks in the euro area and in accession countries. (Source: Fidrmuc
and Korhonen 2003)
fastest growing countries in the European in the sample period, is as
low as the correlation of the average new member country. Fidrmuc
and Korhonen (2004) have updated their earlier study to examine the
correlation of new member countries supply and demand shocks with
the euro area (the sample period is extended to 2002). They nd that
the slowdown of the economy increased the heterogeneity within the
European as well as within new member countries. This is particularly
true for demand shocks. Among the new member countries, Poland
appears to have the highest correlation of supply shocks (above 0.6).
The Czech Republic, Hungary, and Latvia all have correlations of approxi-
mately 0.2. This is roughly comparable to the situations of Denmark
and Greece. For Estonia, the correlation of both shocks is small, and for
Lithuania and Slovakia correlation of supply shocks is negative.
Similar studies were done by Horvath (2000), Frenkel and Nickel
(2002), and Spel (2003). Whereas Horvath nds that idiosyncratic
shocks are prominent in the accesion countries, Frenkel and Nickel con-
clude that several individual CEECs exhibit shocks and shock adjust-
ment processes that are fairly similar to some euro area countries.
Spels main ndings are that supply and demand shocks in Hungary,
Poland, and Slovenia are positively correlated with shocks in the euro
area, while Lithuanias correlation in both demand and supply shocks
is negative. The Czech Republic and Slovakia are found to be positively
correlated with the euro area in terms of their supply shocks but not
in terms of demand shocks.
Table 6.12 compares the results of Fidrmuc and Korhonen with those
of Horvath (2000) and Frenkel and Nickel (2002) in somewhat more
detail.
15
It follows that there is wide variety in results across these three
studies. Take, for example, the ndings for Poland. Frenkel and Nickel
report supply shocks in Poland to be negatively related with supply
shocks in Germany, while Horvath nds close to zero correlation.
Fidrmuc and Korhonen report supply shocks in Poland to be positively
related to similar shocks in the euro area, but Frenkel and Nickel nd
a positive correlation. Also the correlations of the demand shocks in
Poland and Germany vary considerably.
Finally, Korhonen (2003) uses a somewhat different methodology. He
examines monthly indicators of industrial production in the euro area
and nine new member countries. VARs are estimated for each country.
If a euro area shock is quickly reected in production, this is consid-
ered as evidence of symmetry of the business cycles. Korhonen nds
that some of the advanced new members (especially Hungary) exhibit
198 Chapter 6
a high correlation with the euro area business cycle. Moreover correla-
tion seems to be at least as high as in some smaller countries in the euro
area like Portugal and Greece.
Table 6.13 summarizes all studies discussed so far. The main message
stemming from the analysis is that most new member countries
are subject to different macroeconomic shocksand thus a different
business cyclethan the current euro area. Although according to
some estimates the more advanced new members have business cycle
Table 6.12
Correlation of exogenous shocks between euro area, Germany and accession countries
(vector autoregressive estimations)
Supply shocks Demand shocks
Country Germany EMU Germany EMU
a b c a a b c a
Bulgaria 0.462 -0.03 0.280 0.250 0.03 -0.224
(-0.03) (-0.14)
Czech 0.538 -0.05 0.04 0.052 0.321 0.10 -0.15 -0.213
Republic (0.18) (-0.06)
Estonia 0.036 0.08 0.25 0.339 0.343 0.05 0.12 -0.241
(0.02) (-0.00)
Hungary 0.263 0.28 0.46 0.726 -0.197 -0.40 0.25 0.122
(0.20) (0.20)
Latvia 0.022 -0.07 0.30 0.333 0.260 0.11 -0.49 -0.428
(0.16) (0.02)
Lithuania -0.16 -0.11 0.33 -0.49
(-0.31) (-0.35)
Poland -0.494 0.00 0.08 -0.690 -0.200 0.14 0.28 0.217
(0.67) (0.05)
Romania 0.02 0.03
(0.22) (-0.06)
Slovak 0.384 -0.04 0.05 0.182 -0.097 0.04 -0.05 -0.433
Republic (-0.09) (0.05)
Slovenia 0.434 0.02 0.15 0.658 0.049 0.03 -0.18 -0.147
(0.19) (-0.21)
Source: update of Horvath (2003).
a. Frenkel and Nickel (2002); quarterly data for the period 1993:I to 2001:IV.
b. Horvath (2000); quarterly data for the period 1993:I to 2000:III, for Hungary 1995:I to
2000:III.
c. Fidrmuc and Korhonen (2003), quarterly data for 1991 to 2000. In parentheses the
updates of Fidrmuc and Korhonen (2004) are shown; the latter refer to the period 1991
to 2002.
N
e
w

M
e
m
b
e
r

C
o
u
n
t
r
i
e
s
1
9
9
Table 6.13
Summarizing recent literature on business cycle synchronization: New member countries
Period
Study Countries (longest) Comparison Method Conclusion
Horvath CZ, ES, HU, 1993:I FR, GE, IT, Correlation of shocks Low correlation with GE; HU and SI have the
(2000) LA, LT, PL, 2000:III UK determined by SVAR highest supply shocks correlation, while LT has
SL, SI the highest demand shock correlation.
Fidrmuc CZ, HU, PO, 1991/3:01 GE Correlation of High correlation notably for HU, SL (only for
(2001) SL, SI 1999:12 detrended industrial GDP), SI; for CZ correlation of GDP is almost
production and GDP zero
Frenkel and BU, CZ, ES, 1993:I EMU as a Correlation of shocks Wide variety of results, correlation of supply
Nickel (2002) HU, LA, PL, 2001:IV whole and determined by SVAR shocks somewhat higher than those of demand
SL, SI individual shocks. Country with highest supply (demand)
countries shock correlation with EMU is HU (PO); most
countries have negative demand shock
correlation.
Fidrmuc and BU, CZ, ES, 1991:I Euro area and Correlation of shocks Wide variety of results, correlation of supply
Korhonen HU, LA, LT, 2000:IV Euro area determined by SVAR shocks somewhat higher than those of demand
(2003) PL, RO, SL, SI countries shocks. CR, LA, LT, SL, SI have negative
demand shock correlation. Country with highest
supply (demand) shock correlation is HU (PO).
Berger et al. CZ, CY, ES, 1990:01 Euro area Correlation of Low correlations except for CY and SI.
(2004) HU, LA, LI, 2001:12 detrended industrial
PO, SL, SI production (HP)
EFN (2004) CZ, ES, HU, 1993:1 AU, GE, IT, Stylized facts analysis; High correlation of industrial production with
LA, LT, PL, 2002:12 Euro area correlation of detrended euro area, notably for HU, PO, SI; negative for
SL, SI industrial production LA, LT
and GDP
2
0
0
C
h
a
p
t
e
r

6
Table 6.13
(continued)
Period
Study Countries (longest) Comparison Method Conclusion
Spel (2003) BU, CZ, ES, 1996:01 Euro area, Correlation of detrended High correlations with euro area for GDP for
HU, LA, LT, 2002:6 GE, Big 5 industrial production HU, PO, SI; negative for SL, CZ, LT. For
PL, SL, SI and GDP (HP); industrial output HU, PO and ES have highest
correlation of shocks correlation with euro area; LT and RO have
determined by SVAR negative correlation. Demand shocks negatively
correlated with euro area in CZ, SL, LA, LT, ES.
Highest supply shock correlation in HU, PO, SI.
Fidrmuc and BU, CZ, ES, 1991:I Euro area Correlation of shocks Low-demand shock correlations (negative in
Korhonen HU, LA, LT, 2002:II determined by SVAR BU, CZ, LT, SI, RO) higher supply shock
(2004) PL, RO, SL, correlations, notably for PO; negative for BU, LT,
SI SL; lower correlations than in Fidrmuc and
Korhonen (2003a)
Korhonen CZ, ES, HU, 1992:3 Euro area Correlation of VAR Correlations vary widely, but they are
(2003) LA, LT, PL, 2000:12 impulse functions, comparable with those of Greece, Ireland, and
RO, SL, SI industrial production Portugal.
Darvas and CZ, ES, HU, 1993:I Euro area Several measures of HU, PO, SI have achieved a high degree of
Szapry LA, LT, PL, 2002:IV synchronization, synchronization with the euro area for GDP,
(2004) SL, SI including correlation of industrial production and exports, but not for
detrended GDP and consumption and services. The other accession
components countries have achieved less or no
synchronization. All accession countries have
minimal or negative correlation with the euro
area cycle of private consumption and services.
Note: AU = Austria, BU = Bulgaria, CZ = Czech Republic, CY = Cyprus, ES = Estonia, FR = France, GE = Germany, HU = Hungary, IT = Italy,
LA = Latvia, LT = Lithuania, PL = Poland, RO = Romania, SL = Slovakia, SI = Slovenia, UK = United Kingdom, HP = Hodrick-Prescott lter,
SVAR = structural vector autoregressive model, VAR = vector autoregressive mode.
correlations comparable to those of some current members in the euro
area, it is clear that enlargement of the monetary union will imply more
cyclical diversity among the countries in the union at least in the short
and medium term. The fact that business cycle synchronicity in some
of the new member countries seems to be similar to that of some small
countries in the euro area only reinforces this conclusion. In the absence
of reform of the present ECB framework, this could have an adverse
impact on monetary policy making in the euro area, as was pointed out
in chapter 5.
6.3.2 Ination
It is often argued that due to the Balassa-Samuelson effect, transition
countries experience an appreciation of their real exchange rates. As a
consequence of economic restructuring, many transition countries
experience rapid productivity growth in their industrial sectors. As
productivity growth in the traded goods sector exceeds that in the non-
traded goods sector, nontraded goods prices should increase due to the
wage equalization process between both sectors. When productivity
growth in the transition countries exceeds productivity growth in the
countries in the euro area, the transition countries should have a higher
ination rate. According to Eurostat (2001), average productivity in
manufacturing in transition countries was only about 40 percent of the
EU average in 1998. Therefore we can expect further high productivity
growth. This restructuring will, however, take some time. During
restructuring these countries will probably experience higher ination
than the current EMU countries. This raises two questions. First, how
big are these ination differentials between current and potential future
EMU members? Second, what are the policy implications?
There is clearly no consensus in the literature on the magnitude of
the Balassa-Samuelson effect in the transition countries. Table 6.14
provides a summary of various recent studies. Estimates vary widely.
Whereas Rogers (2001), for instance, estimates that the Balassa-
Samuelson effect is likely to imply two additional percentage points of
annual ination in the new member economies, gert (2002a, b) nds
little evidence of a higher ination rate due to the Balassa-Samuelson
effect in the Czech Republic and Slovakia. The extremely high ination
differentials implied by sectoral productivity developments and labor
shares for Hungary and Poland as reported by Back et al. (2002) attract
attention. The gures of these authors reect mainly the massive gains
in productivity in the tradable-goods sector that were achieved during
202 Chapter 6
the 1990s in these two countries. They argue, however, that past gures
are probably not a good guide for the future as convergence implies
that productivity increases will decelerate as higher productivity levels
are reached.
Some of the diverging outcomes in the literature are the result of dif-
ferences in method. An important factor is that not all studies summa-
rized in table 6.14 are restricted to estimates of the Balassa-Samuelson
effect. The cited studies have pointed out various other channels that
can give rise to ination differentials. Some authors take these into
account. For instance, Halpern and Wyplosz (2001), who estimate the
Balassa-Samuelson effect for a panel of nine transition countries
(including Russia), include demand factors. The same is true for
Coricelli and Jazbec (2001), who in addition add a variable that cap-
tures structural misalignments. A very different estimation procedure
has been followed by Pelkmans et al. (2000). These authors base their
estimation on relative price levels in new member countries compared
to existing EMU member countries rather than on productivity growth
differentials. The authors proceed in four steps. First, they regress the
deviation of ination rates of euro area countries from the euro area
average on the relative consumer price levels of these countries. Next,
they regress the relative consumer price levels of 29 OECD countries
on the GDP-based comparative price levels of these countries (i.e., on
ratios of GDP measured in PPP and at current exchange rates). The
coefcients of the independent variables in both equations are negative
and highly signicant. In a third step, Pelkmans et al. (2000) calculate
the relative consumer price levels of the 10 Central and Eastern
European countries, based on their comparative price levels and the
coefcient estimated for the OECD countries in the second equation.
Finally, these authors use the coefcient estimated in the rst equation
for the euro area countries to compute the new member countries
ination differentials from the average euro area, which are implied by
their relative consumer price levels. Their results show on average an
ination differential of 3.8 percentage points.
As to the policy implications, the evidence reviewed suggests that at
least according to some estimates of the Balassa-Samuelson effect, new
member countries with a xed exchange rate regime may have
problems in meeting the ination criterion of the Maastricht Treaty.
Countries with a somewhat more exible exchange rate regime are
unlikely to have problems to meet the Maastricht criteria for Balassa-
Samuelson reasons. The Balassa-Samuelson effect is not likely to
Table 6.14
Estimates of the ination differentials (%) in the transition countries
Vis--vis
Study Countries (if relevant) Size
Jakab and Hungary 1.9
Kovacs (1999)
Pelkmans CEE 10 29 OECD countries 3.8
et al. (2000)
Rother (2000) Slovenia 2.6 during 199398
Czech Republic Germany 2.88
Hungary 6.86
Poland 4.16
Sinn and Slovenia 3.38
Reuter (2001) Estonia 4.06
Halpern and Panel of 9 transition Based on model for 2.93.1 for the period
Wyplosz countries (including service-to-consumer 199199
(2001) Russia) goods price ratio
Corizelli and Panel of 19 Based on 1 in the medium term
Jazbec (2001) transition countries model for relative (199098)
price of tradable
goods
De Broeck Panel of transition On average 1.5
and Slk countries
(2001)
gert Czech Republic Germany 0.648
a
0.303 for
(2002a) 19912000
2.589 1.295 for
Hungary 19912000
3.245 1.901 for
Poland 19912000
-0.154 -0.075 for
Slovakia 19932000
1.321 0.661 for
Slovenia 19932000
gert (2002b) Panel of Czech Germany With share of
Republic, Hungary, nontradables as in
Poland, Slovakia, GDP it ranges from
and Slovenia 0.094 to 1.903
depending on time
period and data.
Estimates for
19962001 period
range from 1.707 to
1.903. With share of
nontradables as in
CPI the latter range
from 0.810 to 1.059.
204 Chapter 6
exhaust the 15 percent bands of ERM II in two years (Buiter and Grafe
2002). If the lower estimates of the Balassa-Samuelson effect are closer
to the truth, new member countries with xed exchange rate regimes
will meet the ination criterion. In fact the countries with a currency
board have the lowest ination rates among the new member coun-
tries.
Some observers have argued that the convergence criteria should be
modied (e.g., see Coricelli and Jazbec 2001). One could, for instance,
compare the ination rates of the new member countries with those in
the least developed EMU countries or allow for a higher than the 1.5
percentage point differential. These suggestions have met little support
from the current monetary union members. Admitting countries with
relatively higher ination rates could increase the HICP ination in the
euro area. However, this argument should not be overstressed as the
weight of ination in the new member countries in the total euro area
ination rate is quite low (about 6 percent). For instance, a 3 percent
difference in ination rates between the 1998 Accession Group and the
rest of the euro area would only imply a 0.1 percent increase in the euro
areas GDP-weighted ination (gert 2002a).
More important, however, is that the increase in the dispersion of
ination rates in the euro area may increase the risks implied by the
decentralized setup of the ECB (see chapter 5). Since the catch-up
process of the new member countries will continue after they have
joined EMU, the enlargement of the monetary union may in time
display more ination divergence within the union. If national consid-
erations play a role in the behavior of national central bank governors
in the Governing Council of the ECB, it is more likely that the focus on
Table 6.14
(continued)
Vis--vis
Study Countries (if relevant) Size
Back et al. Czech Republic, Main trading 0.35 19952000
(2002) Hungary, partners
b
3.84 19952000
Poland, 9.76 19952000
Slovenia 3.88 19952000
a. First gure shows results using GDP deator; second gure shows results with
CPI.
b. Under the assumption that there are no productivity-ination differentials between
tradable and nontradable goods in the main trading partners, which seems unrealistic.
euro area-wide developments will be undermined. From this perspec-
tive, the future enlargement of the monetary union only underscores
the need for reform of the ECB.
6.3.3 Monetary Transmission and Financial Structure
As pointed out before, differences in nancial structure may lead to
diverging transmission of monetary policy measures. Although the evi-
dence for the current euro area is rather mixed (see section 5.6.2), many
authors have argued that the important differences between the current
and future euro area countries in terms of their nancial systems may
lead to differences in monetary transmission between both groups.
As far as the new member countries are concerned, there is only scant
evidence on differences in monetary transmission among countries.
Hardly any attempts have been made to compare the transmission
mechanisms of these countries with one another.
16
The evidence gen-
erally relates to just one or a few countries, while the link with nan-
cial structure is often absent in these studies.
Economic research on monetary transmission in transition countries
is hampered by three major constraints. First, a lack of usable data caps
the number of econometric tools that can be used. Second, the quality
of the available data is often low. It is well known that many, if not
most, macroeconomic time series are subject to measurement errors of
unknown importance, and this seems to apply, in particular, to transi-
tion countries. Third, a highly dynamic economic environment makes
it difcult to separate the effects that stem from a specic development.
Conditions for research will slowly improve over time as time series
data accumulate and as the reform process associated with postsocial-
ist transition and the preparations for EU accession come to an end.
There are three main approaches used to investigate monetary trans-
mission in transition countries (Ganev et al. 2002). The rst research
method includes rather unsophisticated comparison techniques by
which general inferences are made on what might have happened
under different circumstances. A second, more formal approach
involves the construction of (small) structural macroeconomic models.
These models are used to investigate the development of certain
economic indicators under specic monetary conditions in a highly
stylized environment.
17
The third research method is based on vector
autoregressions (VARs). This type of econometric modeling generally
enables the researcher to limit the number of strong theoretical con-
straints used to investigate the effects of monetary policy.
Studies in which the VAR methodology has been used include
Durjasz (2001), Gottschalk and Moore (2001), and Christoffersen et al.
(2001) for Poland, and Kuijs (2002) for the Slovak Republic.
Maliszewski (2002) compares monetary transmission in Poland and
the Czech Republic, while Ganev et al. (2002) present VARs for ten
transition countries. Unfortunately, the various studies cannot be
directly compared because they refer to different sample periods and
also employ rather diverse modeling strategies.
Still, despite the wide variety of models, some general conclusions
can be drawn from these studies (Elbourne et al. 2003). Not surpris-
ingly, many studies nd evidence that the monetary transmission
mechanism is unstable over time. Furthermore the reported impact of
monetary policy measures is often counterintuitive. Durjasz (2001), for
instance, reports that the Polish experience suggests that only after the
implementation of direct ination targeting (which was introduced in
Poland in late 1998) reasonable transmission patterns emerged.
Another conclusion that is found in many papers is that the exchange
rate mechanism is more powerful in various transition countries than
the interest rate channel. In countries that have relatively exible
exchange rate regimes, the exchange rate channel is the dominant way
in which monetary contractions affect ination. Gottschalk and Moore
(2001), for instance, nd that prices respond usually within a year to a
shock in the nominal exchange rate. The price level does decline in
response to an interest rate hike, but this effect is not clearly signicant.
Also the evidence for the Slovak Republic reported by Kuijs (2002) sug-
gests a strong exchange rate channel.
Although there is broad agreement about the importance of the
exchange rate channel, there is less agreement over whether this dom-
inance remains in the more recent period. According to Hamecz (2001),
the dominance of the exchange rate channel under the tightly managed
exchange rate regime became less clear after the Hungarian central bank
switched to ination targeting in mid-2001. However, Maliszewski
(2002) concludes that the exchange rate channel is still dominant in
Poland and the Czech Republic.
One of the most comprehensive VAR studies is by Ganev et al. (2002),
who report impulse responses of industrial output, ination, and the
exchange rate to a one standard error interest rate shock involving ten
transition countries. Their study only covers the period January 1995
to December 2000, however. The positive short-term interest-rate shock
brought about very different reactions of industrial output in different
206 Chapter 6
countries. It dampened output in the short run in Slovakia, Hungary,
and Slovenia while it raised it in Lithuania, Estonia, the Czech Repub-
lic, and Poland. Latvia, Bulgaria, and Romania had a mixed pattern.
The impact seemed to ease off after 12 months in most countries. Like-
wise the core ination response to interest rate shocks varied across
countries. In some, namely Lithuania, Hungary, and Slovenia, the
response was consistent with theory in that higher interest rates damp-
ened ination. In Bulgaria after initial boost, ination subsided. In
Slovakia and the Czech Republic an interest rate shock raised ination
persistently and led to higher ination over the three years following
the shock. In Romania there was an instability problemthe core ina-
tion is still on the rise after three years.
Also Elbourne et al. (2003) estimated VARs for ten transition coun-
tries. Apart from ination and output growth, these authors use the
deposit rate and the lending rate as interest rates in the models. For
those countries that had either a currency board or a fully xed
exchange rate for a large proportion of the sample period, they
modeled the exchange rate as an exogenous variable. For the others,
that had either oating exchange rates or crawling pegs, the exchange
rate is endogenous. All variables are dened in the form of their devi-
ation from their stochastic trend. German output growth, the German
call money rate, and commodity prices are included as exogenous vari-
ables, as are dummy variables to take into account the effects of the dif-
fering exchange rate regimes and nancial crises. Although the results
of this study differ from those of Ganev et al. (2002), Elbourne et al.
(2003) also conclude that there appear large differences in monetary
transmission among the countries considered. Table 6.15 is reproduced
from this study. It shows the effects on ination and output growth of
a 100 basis points shock to the domestic deposit rate. The table shows
the peak impact of ination and output growth after the monetary
shock, the time (in months) it takes before this maximum is reached,
as well as the cumulative impact of the shock over a three-year period.
The nancial structure of the transition countries differs from that of
the current monetary union members. As banks play an important role
in the transmission of monetary policy, table 6.16 shows a number of
key indicators for the banking system of the transition countries. Bank
assets in relation to GDP are almost three times higher in the euro area
than in the transition countries. Of course, this does not imply that the
credit and bank lending channels are less important in the new member
countries, as capital markets are still in their infancy. As Buiter and Taci
(2002) argue, the nancial systems in the transition countries have
developed more as bank-based systems than as market-based systems.
Given the insufcient scope and effectiveness of legal contract enforce-
ment and with inappropriately or imprecisely dened property rights,
these countries had no alternative but to develop a relationship-based
nancial system, with banks as the main nanciers.
Comparative research on the relationships between the nancial
structure and monetary policy transmission in the transition countries
is scarce. Elbourne et al. (2003) use a similar approach to that suggested
by Cecchetti (1999). They gathered various indicators for the nancial
structure in the transition countries and put them into three categories:
indicators for the importance of small banks in a countrys nancial
system, indicators for the health of the banking system, and indicators
for the importance of external nance. In contrast to Cecchetti (1999),
they do not combine the indicators into one single nancial sector indi-
cator as this is a rather subjective and ad hoc procedure. Instead,
Elbourne et al. (2003) use rank correlation coefcients of the estimated
impact of monetary policy decisions as reported in table 6.14 and the
various nancial structure indicators. They nd no clear evidence of a
relation between nancial structure and the impact of monetary policy
shocks as most of the correlations are not signicant.
208 Chapter 6
Table 6.15
Summary of impulse responses of VAR model for 10 transition countries
Ination Output growth
Peak Time Sum 36 Peak Time Sum 36
Country impact (months) months impact (months) months
Bulgaria -5.30 3 -16.38 -0.12 5 -0.32
Czech Republic -0.70 7 -3.09 -2.25 5 -6.47
Estonia -0.18 10 -1.78 -0.58 5 -2.20
Hungary -0.28 1 1.43 -2.07 3 -9.92
Latvia -0.46 5 -4.71 -0.87 2 -4.49
Lithuania -0.84 7 -8.51 -0.71 1 -1.30
Poland -0.18 2 -1.61 -0.64 6 -5.93
Romania -0.20 5 -1.89 -0.13 1 -0.25
Slovak Republic -0.28 4 -1.30 -0.59 2 3.26
Slovenia -0.08 2 0.01 -0.11 2 -0.89
Source: Elbourne et al. (2003).
N
e
w

M
e
m
b
e
r

C
o
u
n
t
r
i
e
s
2
0
9
Table 6.16
Some indicators of the banking sector in transition countries (2000)
Assets share Loans share Deposits share Domestic Nonperforming Average Net Average rate
of ve largest of ve largest of ve largest credit of banks loans (as % of capital interest of return on
banks (%) banks (%) banks (%) (% GDP) loans) ratio margin assets
Bulgaria 60.5 NA NA 25.6 10.9 0.1 4.1 4.1
Czech Republic 66.1 67.5 74.5 56 19.3 4.6 2.1 0.5
Estonia 98.8 99.5 99.5 38.1 1.5 12.6 0 1.1
Hungary 53.3 52.9 61.5 35.2 3.1 8.8 3.7 1.3
Latvia 62.3 71.9 66.2 21.7 5 8.4 4 2
Lithuania 88.5 85 93 16.8 10.8 10 3.6 0.4
Poland 48.6 48.4 49.1 36.5 15.9 8.2 4 1.1
Romania 70.1 65.4 NA 8.9 3.8 NA 7.4 2.3
Slovak Republic 63.4 63.8 69.1 61.4 26.2 6.4 1.8 0.5
Slovenia 62.5 49.1 53.2 44.6 8.5 8.1 4.2 1.1
Source: Buiter and Taci (2002).
210 Chapter 6
6.4 Conclusions
EMU is being enlarged over time. Some of the new member countries
will join EMU some two years after their EU entrance. Central bank
independence is a prerequisite for EU membership. The new member
countries must grant their central banks in legal terms a very inde-
pendent position. However, the analysis of actual independence,
proxied by the turnover rate of central bank governors, sometimes sug-
gests deviations from the law.
All new EU members have an obligation to join the EMU, but a
new member has to fulll the convergence criteria stipulated by the
Maastricht Treaty before it can enter. This is a way of ensuring equal
treatment of member countries in the euro area. The adherence to the
convergence criteria can be problematic. One critical issue is the need
to fulll the budget decit criterion. Another is achieving exchange rate
stability, by which the currency must respect the normal uctuation
margin of the ERM II. All new member countries have to adhere to the
ination criterion. Recent estimates of the Balassa-Samuelson effect do
suggest that the ination criterion can probably be fullled. Quick
entry is a sensible strategy from the perspective of the new members,
since there are benets involved. One is a lower interest rate after enter-
ing the EMU, which makes budgetary consolidation easier to accom-
plish. The shorter the period accession countries must wait, the lower
are the risks of exchange rate instability. For the accession countries
with currency boards that have demonstrated over the years that they
can live with a unilaterally xed exchange rate, the wait is especially
difcult.
As the monetary union enlarges, reform in the decision-making
process of the ECB will become more critical. The disparate business
cycles, inations, and monetary transmissions could increase within a
larger monetary union. Most new members have business cycles that
differ from that in the euro area. Over the long run these idiosyncrasies
will probably be lessened as a consequence of full convergence, but the
idiosyncrasies will certainly not disappear in the short and medium
term. This impact will be felt in monetary policy making in the euro
area, but a reform of the ECB framework could avoid this.
Although interpretations of the so-called Balassa-Samuelson effect
differ substantially, the new EMU members can be expected to have
higher ination levels than the older members. While this does not
seem particularly serious in the impact on euro area wide ination, the
increased divergence of ination within the euro area may cause the
decision making of the ECB to become more focused on individual
cases than on ination in the euro area as a whole.
Alot of authors have already argued that the big differences in nan-
cial systems between current and prospective euro area countries can
lead to differences in monetary transmissions between both groups.
There is agreement over the importance in the past of the exchange rate
mechanism compared to the interest rate channel, but there is less
agreement over whether this dominance will continue. In the nancial
structures of the transition countries, banks play an important role in
the transmission of monetary policy because capital markets are still in
their infancy. Although there is mixed evidence that the impact of
monetary policy shocks depends on nancial structure, enlargement of
the monetary union may imply more structural diversity in monetary
transmission within the union. So ECB policy decisions may have dif-
ferent impacts on the various countries comprising the union.
Our ndings in this chapter therefore support our argument in
chapter 5, that a reform of the ECB in which economic and political
weights are brought more in line with each other is needed. In chapter
7 we discuss some ways to reform the ECB.
7.1 Introduction
The Governing Council of the ECB currently has 18 members6
Executive Board members and 12 national central bank governors, one
for each of the 12 euro area countries. In principle, all members have
equal weight in the decision-making process. However, eighteen
members have already proved too many from the point of view of
effective discussion, deliberation, and decision making. Enlarging an
unreformed ECB to include up to some 15 additional national central
bank governors could turn the Governing Council into an unwieldy
and unmanageable group of 33 members. The central banks tradition
of consensus-based policy makingsaid to have an important place in
todays ECB decision-making processcould further amplify the
ECBs numbers problem and raise decision-making costs. Baldwin et
al. (2001) argue that the practice of the Executive Board to initiate
Council decisions will become seriously impaired as the number of
euro area member countries increases and the Boards relative power
decreases.
Likewise the increase of euro area member countries without reforms
could broader the wedge between the economic and political weights of
countries in the euro area (see gure 7.1). Since nearly all accession
countries are small in economic terms relative to current euro area
members, enlargement within the given institutional setup may lead
to signicant overrepresentation of the areas smaller member coun-
tries in the Council. For instance, in a monetary union with 27 members
the current ECB statute implies that the representatives of its smallest
17 member states, representing only about 10 percent of the areas
aggregated GDP, can determine monetary policy for the entire euro
7
Options for Reform
214 Chapter 7
area (Berger 2002). Without a reform of the ECB, nearly 80 percent of
the countries will have larger political than economic weight. If the
one person, one vote principle is strictly applied, all newcomers but
the United Kingdom will be allocated a political weight that surpasses
their economic weight, and in most cases by a substantive margin
(Berger et al. 2004).
Overrepresentation can introduce an unwelcome bias into the ECBs
decision making if country representatives try to put some weight
on national economic developments and these developments deviate
signicantly from the behavior of euro area aggregates. As we have
argued in chapters 5 and 6, there is reason to believe that such asym-
metries can affect ECB policy making. In this chapter we will therefore
evaluate various ECB reform options from three perspectives: (1) deci-
sion-making costs, (2) the gap between economic and political weights,
and (3) political feasibility. Section 7.2 discusses various reform options,
while section 7.3 zooms in on the proposal put forward by the ECB.
Section 7.4 concludes.
0 5 10 15 20 25
GER
GBR
FRA
ITA
ESP
NLD
SWE
BEL
AUS
POL
DNK
FIN
GRC
PRT
IRL
CZE
HUN
RO
SVK
LUX
SVN
BGR
LTU
CYP
LVA
EST
MLT
Share (%)
Economic weight (EW)
Political weight (PW)
1 Council seat
Figure 7.1
Economic and political weights of central banks after enlargement of the euro area.
(Source: Berger et al. 2002)
7.2 Options for Reform
Among the ways of reform voiced for the ECB (see Berger 2002), are
centralization (the Executive Board will become responsible for policy
decisions), vote-weighting (the vote of a national central banker
depends on the size of the economy), representation (one central
banker represents various central banks), extending regional central
banks across national borders, and rotation (the governors of national
central banks have rotating voting rights).
Baldwin et al. (2001) argue for more centralization. The pragmatic
version of centralization would put a policy decisions into the hands
of the ECB Executive Board. This, of course, would limit the role of the
Council to that of an informational forum in which the areas regional
central banks would be apprised of policy decisions and implementa-
tion issues would be discussed.
Alarger role for the Executive Board in ECB decision making can go
a long way toward limiting decision-making costs and preventing any
diverging economic developments within a larger euro area to have an
undue impact on monetary policy in the euro area. The EU Treaty spec-
ies that the Board is appointed by the governments of the member
states at the level of Heads of State or Government, on a recommen-
dation from the Council, after it has consulted the European Parliament
and the Governing Council of the ECB (EU 1997, Article 112.2b). This
highly centralized political process at the European level should
support a euro area-wide perspective of the nominees selected for the
Board. However, the political feasibility of centralization seems limited.
The principle one person, one vote is an important feature of the
current ECB framework also in day-to-day monetary policy making.
As the ECB Statute clearly states, Each member of the Governing
Council, shall have one vote (EU 1992, Article 10.2), and this includes
the national central bank governors. An equal right to participate in
ECB policy decision making was thus an integral part of the Maastricht
Treaty that established the currency union. Clearly, a reform of the ECB
that fails to safeguard the established voting rights of current member
countries central banks will not be politically acceptable. Some
member governments have already experienced opposition in letting
go the last bit of inuence on ECB policy making after having
exchanged monetary sovereignty for a seat at the ECB Council in 1999.
Aversion of this scheme that only slightly departs from full central-
ization and meets some of these objections was put forward by Gros
Options for Reform 215
216 Chapter 7
(2003), who argues in favor of redening the division of labor between
the Executive Board and the Governing Council. The function of the
Governing Council would be exclusively in the direction of monetary
policy, whereby the Council would decide on proposals from the
Executive Board, constitute a platform for the exchange of views on the
euro area economy, and monitor the work of the Executive Board.
These are tasks that can be performed efciently by a large body com-
posed of representatives of all member countries, and the Governing
Council provides the appropriate legitimacy for such a controlling
institution. Gros sees the primacy of the Governing Council as not
affected, in that all powers would continue as mandated by the EU
Treaty. This plan does, however, reduce the right of the Governing
Council to control every single act of the Executive Board. Thus the
Executive Board would come to enjoy a certain degree of discretion, as
is justied by the fact that it represents not only an aggregation of indi-
vidual state interests but a general European monetary interest.
According to Gros, this division of labor is based on one key difference
between NCB presidents and members of the Board: their respective
information bases. Board members concentrate on area-wide aggre-
gates in their daily work and are likely to be in closer contact with
global nancial markets than the NCB presidents. The latter perform a
wide variety of functions at the national level: they supervise the
national banking system, they are inuential participants in national
debates about almost all economic policy issues, and so on. By contrast,
the members of the Board can concentrate almost exclusively on issues
related to the formulation of the common monetary policy stance.
Although we are quite sympathetic toward this reform proposal, we
doubt that it can sufciently address the potential gap between politi-
cal and economic weight. This is because in the Gros (2003) proposal
all national central bank governors keep one vote in the Governing
Council and the Council still decides on the direction of monetary
policy. In a scheme proposed by Bonger (2003), a similar setup is
favored whereby the Executive Board takes decisions on interest rates
and the Governing Council is allowed veto power over interest rate
decisions. This scheme only brings us back basically to the current
situation. Furthermore it seems that the political feasibility of reform
to give the Executive Board more power is limited.
Berger et al. (2003) suggest a type of reform in which economic size
and political power are matched as closely as possible. When countries
have as much voting power as GDP share, deviations from a purely
European perspective by Council members would not have an
undue inuence on monetary policy in the euro area. There are basi-
cally four options here: vote-weighting, representation, extending
regional central bank jurisdictions across national borders, and rota-
tion.
1
For instance, under vote-weighting, the votes of non-Board
members of the ECB Council would be weighted in terms of a member
countries share in euro area GDP. By denition, a reform along this
line could better align the political and economic weights of the
national Council members. Vote-weighting has a precedence in the
qualied voting schemes of the EU Council, which the Treaty of Nice
updated in the rst EU enlargement.
Yet another voting scheme that takes into account differences in
economic size is the idea of a required double majority of votes and
population. Under such a system there is still an equal voting right
for all Board members. Every decision requires a majority of the votes.
In addition, however, it is also required that the votes in favor repre-
sent a majority of the population of the euro area. An alternative would
be to require that these votes represent a majority of the euro areas
GDP.
A problem with any of these vote-based reform scenarios is clearly
that they do not necessarily address the problem of decision-making
costs. Decision-making costs in the narrow sense of voting on interest
rate changes, say, do not need to be made so problematic. The Councils
decision-making process involves more than a simple aggregation of
votes, it also includes a more or less extensive discussion of the views
of all members. In this regard weighting votes does not necessarily
solve the ECBs large number problem. In fact, just like the argument
made in opposition to the centralization solution, it should be noted
that a weighted-voting scheme can interfere with the one person, one
vote principle embedded in the ECB Statute, although somewhat less
than may apply to the double majority system.
An alternative reform scenario is representation that combines some
of the characteristics of the centralization and the weighing approaches.
The principal idea is to create groups of euro member countries with
joint representation and joint voting rights in the ECB Council, inte-
grating the concept of a strong regional anchor with the necessity of
restricting the size of the ECBs main decision-making body after
the enlargement.
2
The representation scenario requires a number of
218 Chapter 7
specic institutional decisions, in particular, on group selection. The
selection principle is based on the idea of common economic regions
(taking into account similarities in business cycles or economic struc-
ture), economic size, or both. Related issues are the number of groups,
the overall Council size, and the delegation of voting power from group
members to their representative in the ECB Governing Council. The
alternative institutional designs range from a restricted or imperative
mandate (votes in the Council are predetermined at the group level) to
an unrestricted mandate (group members delegate their full voting
rights to their representatives). However, since the latter arrangement
can, in principle, deprive individual group members of their right to
participate in the decision making, there is a potential conict with the
idea of national representation and the one person, one vote princi-
ple. This makes a solution entailing some form of explicit involvement
of national central banks at the group level before a Council decision
(i.e., a restricted mandate for the group representatives in the Council)
a likely part of any representation scenario. Such a restriction is likely
to encompass contributions to Council discussions as well as formal
voting. In this sense it can alleviate the decision-making costs problem
at the level of the ECB Governing Council. However, the costs will sub-
stantially increase at the level of the group. If the mandate of group
representatives in the Council is restricted, in the sense that their
actions require the explicit consent of group members, the overall time
and effort needed for a Council decision will be of a similar magnitude,
if not higher, as in the previously discussed scenario.
A variant of the representation idea is the extension of central bank
jurisdictions across national borders. For instance, the regional central
banks in the US Federal Reserve System extend their reach over the
borders of some states. Likewise some of the (post-1992) Landeszen-
tralbanken in the Bundesbank Council represent more than one
German state. An application of this principle to the ECB after enlarge-
ment could help reduce the number of decision makers in the Council.
If the design of central bank areas were aimed at establishing regional
banks with approximately similar economic weight, signicant mis-
matches could be avoided between voting power and economic size.
However, as with the previous scenarios, there can be problems of
political feasibility where a reform works to abolish the existing voting
rights of current euro area member states. Furthermore implicit in such
a reform is that one of the basic principles of the current ECB setup,
representation of countries, would be abandoned.
An alternative reform scenario that, in principle, might address both
the mismatch between political and economic weights and the deci-
sion-making problem associated with the enlargement of euro area
membership (while avoiding some of the political constraints dis-
cussed above) could be (asymmetric) rotation. The basic idea is that
national central bank governors would take turns sitting at the Council,
with the frequency of their participation scaled to match the relative
economic weight of their respective country. Rotation would thus work
to weight the votes of national central bank governors in an implicit
fashion. Arguably rotation poses less conict with the one person, one
vote principle than centralization, weighted-voting, or the represen-
tation scenario. Although not all governors can participate in every
Council meeting, those who participate will be casting a full vote. Rota-
tion could also serve to limit the overall size of the ECB Council by
allowing only a fraction of central bank governors to participate in
meetings. The ability to address the potential problems posed by
enlargement while avoiding part of the political feasibility problems
associated with some of the other types of reform makes the rotation
scheme a good structural solution for ECB.
Berger et al. (2004) recognize that in basing representation on GDP
size, more than 50 percent of the euro areas GDP is guaranteed to
always have a voice in the Council. Again, the principle of equal voting
rights is lost. The easiest way to ensure that always more than half of
the euro areas GDP is represented is to give the Big Five a perma-
nent seat in the Governing Council. If this turns out to be politically
unacceptable, one could consider a system in which the Big Five also
rotate, but substantially less than the other countries. Berger et al.
(2004) present the example of four seats for the Big Five, who rotate,
and ve seats for the others, who also rotate.
7.3 The ECB Proposal
In its meeting of December 19, 2002, the Governing Council of the ECB
adopted a proposal for ECB reform after enlargement of the monetary
union.
3
As in the analysis of Berger et al. (2004), the ECB proposal put
a limit on the number of central bank governors exercising a voting
right. However, the ECB put this maximum at 15, instead of 9.
4
Con-
sequently the Governing Council will consist of 21 members, which
may be too large from a decision-making cost perspective. No modern
220 Chapter 7
central bank has a decision-making body this size. Moreover all
members of the Governing Council (with and without voting rights)
will continue to sit at the table and have the right to participate in the
discussion. As Bonger (2003) puts it, in spite of its complexity the
Recommendation clearly fails to meet the main target of the ECBs insti-
tutional reform. The danger that the Council would be paralysed by
too many participants is still there.
The ECB proposes that if the euro area increases to more than 15
countries, there will be two groups with rotating voting rights. The rst
group will consist of the governors of the member states that occupy
the highest positions in the country rankings on the basis of a so-called
composite indicator of representativeness. They share four voting
rights. The second group will consist of all other governors, and they
will share 11 voting rights.
The principal component of the representativeness indicator will
be the member states GDP. The second component will be the total
assets of the aggregated balance sheet of monetary nancial institutions
(TABS-MFI) within the territory of the member state concerned. The
relative weights of the two components are 5/6 for GDP and 1/6 for
TABS-MFI.
Once there are 22 euro area members, there will be three groups with
rotation. The allocation of central banks to the groups will be based on
a ranking according to the composite indicator. The rotation scheme as
proposed by the ECB is as follows: The rst group, which will have
four votes, will be composed of the ve central bank governors from
the euro area member states that occupy the highest positions (the Big
Five). The second group, with eight voting rights, will consist of half
of all national central bank governors selected from the subsequent
positions in the ranking. The third group will be composed of the
remaining governors and will share three voting rights. Thus, when
there are 27 members, the intertemporal voting power of a national
governor will be 80 percent in the rst group, 57 percent in the second,
and 38 percent in the third (Bonger 2003).
The ECB proposal met considerable criticism from academic
observers. Gros (2003) argued, for instance, that the solution proposed
by the ECB is worse than the status quo. It is inefcient, opaque, inter-
nally inconsistent and arbitrary. Apart from critique on the size of the
Governing Council that we share, Gros had the following objections to
the ECB proposal: First, he saw it as compromising the principle of
equality of member states, and thus as potentially undermining the
idea that members of Governing Council should ignore the particular
interests of their home country and act only in the interest of the entire
euro area.
5
As we have argued before, the best way to ensure that
national interests will not unduly inuence ECB policy making is to
bring political power and economic weight of national central bank
governors as closely in line as possible. Even if national central bank
governors take the economic needs of their home countries into
account, this will not necessarily lead to decisions that are much out of
line with the ECBs mandate on price stability in the euro area as a
whole. Some preliminary calculations under the assumption of a 27
member EMU by Berger et al. (2004) suggest that the average share of
GDP represented is high under the reform as proposed by the ECB: 73
percent. Reform along these lines can be expected to overcome the most
important institutional design failure of the ECB.
Second, Gros saw the proposal as lacking clarity. Mainly, it was not
clear to him how the rst group of 5 countries will share four votes.
Will they rotate every meeting, every month, every year? By what
order? What happens to new members of the euro area? We agree that
the ECB proposal has to be better specied, but is seems that these prac-
tical matters do not give good reason to object to the proposal as a
whole.
Third, Gros argued that the ECB proposal is not transparent because
it is too complicated. He saw as arbitrary the weight given to the indi-
cator of the size of nancial markets (one-sixth) and as designed
to ensure a better position for one country, Luxembourg. This way,
according to Gros, Luxembourg is granted larger weight than Finland,
a country with about ten times the population and six times the GDP
of Luxembourg. The third group with the lowest voting power would
consist exclusively of the new members. We agree that the criteria for
determining the voting groups is rather arbitrary. As we pointed out
before, we prefer grouping on the basis of economic size (GDP) only.
Furthermore there should be a clear rule on how often the grouping
can be reconsidered to take into account that the relative size of coun-
tries may change over time. If the new member countries grow faster
than the current euro area countries, they should get a higher voting
share.
Finally, Bonger (2003) argued that the ECB reform proposal would
undermine the independence of the ECB:
222 Chapter 7
[F]rom the experience of the Bundesbank one can see that it is of decisive
importance for the political independence of a federatively structured central
bank system that all regional/national representatives are treated equally
in all respects. This insight is expressed by the principle of ad personam par-
ticipation. It implies that a NCB governor is not regarded as an agent of its
specic region/country but as an expert on monetary policy which takes part
in the discussions and decisions in personal and independent capacity. The
German experience shows that such an institutional set-up leads to a Thomas
Becket effect according to which governors from very different political and
regional backgrounds soon feel a responsibility for the currency area as a
whole. . . . Under the new rules a NCB governor would permanently experi-
ence that his national origin plays a role in the decision-making process. This
could make him prone to decide from a national perspective which threatens
the independence of the ECBs decision-making process from national
considerations.
However, as we showed in chapter 5, there is evidence that voting in
the Bundesbank decision-making body is inuenced by regional eco-
nomic considerations (Berger and De Haan 2002). The best way to mit-
igate any political inuence that is at odds with the aim of price
stability in the euro area appears to be to align political and economic
weights as closely as possible. If politicians put pressure on their
national central banks to improve the economic situations of their
countries, and the central bankers act upon this, there should not be
distorted decision making.
7.4 Conclusions
Clearly, the ECB should be reformed in view of the enlargement of the
euro area. Under the current setup the Governing Council would
become excessively large. From the decision-making cost perspective,
a larger role for the Executive Board would be an attractive option for
reform. If the Board also were to become responsible for monetary
policy making, the risks of a distorted monetary policy would be min-
imized, provided that the Board has a truly euro area-wide focus. If,
however, the Governing Council remains the decision-making body, it
should be reformed to bring the political power and economic weights
of national central bank governors in line as closely as possible. From
this perspective, the rotation system proposed by the ECB is in the
right direction. In this system the likelihood that a national central bank
governor will have voting right depends on the size of the economy of
his home country. However, potential problems remain concerning the
Council size (15 national central bank governors with voting rights and
6 Executive Board members) and the participation of all central bank
governors in the discussions of the Council. In our view, a smaller
Governing Council, with about 15 members, in which only national
central bank governors with a voting right participate could lead
to more efcient decision making than the scheme proposed by the
ECB.
In this book we have focused on two sets of issues: the transparency
and credibility of the ECB, and the decentralized setup of the central
bank in the euro area. We showed that the ECB has a relatively good
overall score on the Eijfnger-Geraats disclosure indicator, which is
due to its good scores for political and economic disclosure. The ECB
also has a high score according to most other indicators for central bank
disclosure. However, an important nding of many surveys, including
our own, is that the ECB is widely considered to be nontransparent by
nancial market participants. The ECB is also considered to be less
credible than the Fed or the (previous) Bundesbank. Our indicator for
accountability suggests that the ECB does not rank high but does go
further than required by law in providing information.
The ECB has been criticized by many acedemics, notably for its mon-
etary policy strategy. Although we agree with some of the criticism, we
believe that the ECB has pursued a successful policy so far. Ination in
the euro area has remained low, although it is often slightly above
rather than below the 2 percent mark. The projected ination rate has
been relatively stable. Most ECB policy decisions have been in line with
market expectations, although there have been occasional surprises.
Despite this favorable assessment we conclude that the ECB can
improve the transparency of its monetary policy in two ways. First, it
should drop altogether the rst pillar and concentrate on a more
explicit ination-targeting strategy. The main problem with the role of
money in the ECB strategy is that it is widely misunderstood by many
observers and therefore creates the impression that the ECB lacks trans-
parency. We think that the ECB should abandon the monetary analysis
as a dominant navigation system for its monetary policy.
The second improvement would be to announce a midpoint ina-
tion target of 2 percent with a range of 1.5 to 2.5. A clear denition of
8
Conclusions
226 Chapter 8
price stability can enhance the transparency and credibility of the ECB.
In our view, the arguments put forward for raising the ination objec-
tive substantially are not compelling. From our reading of the litera-
ture, we see that the consequences of the zero bound are negligible for
target ination rates as low as 2 percent. Likewise the upward mea-
surement bias in ination seems to be less of a problem in the euro area
than in the United States. Also the risk of deation in an individual
country in the euro area seems to be quite small. The evidence on the
Balassa-Samuelson effect is so mixed that we do not consider this to be
a convincing argument for a higher ECB ination objective.
Although we prefer an ination-targeting strategy, we feel that a
change toward ination targeting will not automatically increase the
transparency of the ECB. For example, the Fed and the Bundesbank are
not ination targeters but are perceived to be more transparent than
the ECB; the Bank of England, on the other hand, has an ination-tar-
geting strategy but performs only slightly better than the ECB in terms
of transparency. In other words, ination targeting is neither a neces-
sary nor a sufcient condition for transparency.
The second main issue of the book is the decentralized structure of
the central bank of the euro area. This setup is not necessarily problem-
atic, but it has the potential to introduce an unwelcome bias into the
ECBs decision making if country representatives weigh in their own
national economic developments and these developments deviate
notably from the behavior of euro area aggregates. Already there is evi-
dence that within the euro area, countries diverge in terms of their busi-
ness cycles, ination, andto a lesser extentmonetary transmission.
Quick entry into the monetary union remains the sensible strategy
from the perspective of the new EU members, since it is benecial for
them. Membership euro area means lower interest rates, allowing the
required budgetary consolidation to be easier to accomplish. The
shorter the wait period, the lower are the risks of exchange rate insta-
bility. For countries with currency boards and with well-established
unilaterally xed exchange rates, the advocated waiting is especially
difcult.
The upcoming enlargement of the monetary union supports our
view that reform of the ECB is necessary as it will increase economic
diversity within the union. Business cycles of the new member coun-
tries will not yet be synchronized and ination rates and monetary
transmission will differ. Although an argument can be made that
further economic and monetary integration will reduce this divergence
over time, there is evidence showing that integration does not always
lead to less divergence. We therefore conclude that a reform of the ECB
decision-making structure is needed to reduce the risk of suboptimal
policy making.
For the Governing Council, we favor a reform that brings the polit-
ical power and economic weights of national central bank governors
in line. From this perspective the proposed rotation system goes in the
right direction, since every national central bank governor will have a
voting right depending on the size of its home country economy. To
avoid the potential problem of the size of Council and to forgo national
central bank governors without voting rights to participate in the dis-
cussion, we recommend a smaller Governing Councilin which only
national central bank governors with voting rights participate so that
more efcient decision making can take place in the ECB.
Conclusions 227
Chapter 1
1. At the time of writing, apart from the new EU member countries, also Denmark, the
United Kingdom, and Sweden do not (yet) participate in EMU. Still, it is expected that
at some time these countries will also use the euro.
2. The central banks of the EU member states that do not participate in the euro area are
members of the ESCB with a special status. They are allowed to conduct their respective
monetary policies, but they do not take part in the decision making for the single mon-
etary policy for the euro area and the implementation of such decisions.
3. Since not all EU member states participate in the monetary union, the ESCB also com-
prises central banks from countries that still have their own currency. The Eurosystem,
a subset of the ESCB (excluding central banks of countries that do not participate in the
monetary union), is responsible for carrying out the common monetary policy. See
chapter 2 for further details.
4. For instance, the UK Prime Minister John Major, wrote in The Economist, to recite the
mantra of full economic and monetary union . . . will have all the quaintness of a rain
dance and about the same potency.
5. The ECB also has a number of other tasks. Article 105.2 of the Maastricht Treaty states,
for instance, that the ESCB promote the smooth operation of payment systems.
TARGET (the Trans-European Automated Real-time Gross settlement Express Transfer
system) plays an important role in this respect. TARGET consists of 15 national real-time
gross settlement (RTGS) systems and the ECB payment mechanism (EPM), which are all
interlinked. More than 40,000 banks and branches can be addressed via TARGET. Adaily
average of more than 253,000 transactions (domestic and cross-border) were processed
in 2002, with an average daily value of more than 1,500 billion. TARGETs market share
of large-value euro payment systems trafc is signicant, with the system processing
nearly 85 percent in terms of value and 59 percent in terms of volume.
6. See http://www.imf.org/external/np/mae/mft/.
7. The Economist, Euro Towers or Fawlty Towers? 31 October 1998.
8. Negotiations with Turkey and Croatia about EU membership will start in 2005.
9. See ECB Press Release at http://www.ecb.int.
Notes
230 Notes to Pages 939
Chapter 2
1. The rst part of this chapter draws heavily on Eijfnger and De Haan (2000).
2. Moreover, and without prejudice to the objective of price stability, the ECB is
obligated to support the general economic policies in the Community with a view to
contributing to the achievement of the objectives of the Community. This includes a
high level of employment and sustainable and non-inationary growth.
3. In the HICP market transactions do not include interest rates, owner-occupied
housing, nor business expenditures. Included are consumption expenditures of foreign-
ers in the reference country but excluded are the consumption expenditures of residents
abroad (see Camba-Mendez et al. 2002 for further details).
4. Energy prices constitute 8.2 percent of the HICP in 2003; see ECB (2004).
5. Standard means that the tender is conducted in accordance with a pre-announced
schedule and is completed within a period of 24 hours from the announcement of the
tender to the communication of the results; see ECB (2004) for further details.
6. Introductory statement by Duisenberg before the ECB Press Conference, December 5,
2002.
7. Similarly De Grauwe (2003) states: the ECB is downgrading the importance of the
money stock (M3) in its monetary policy strategy, and rightly so. It just did not make
sense anymore to pretend that the money stock is the most important variable to watch.
This variable is so much polluted by noise that it rarely gave the right warning signal of
future ination.
8. In 2002 the Panel members were Christian de Boissieu, Guillermo de la Dehesa,
Sylvester C. W. Eijfnger, Jean-Paul Fitoussi, Giampaolo Galli, Daniel Gros, Gustav A.
Horn, Lars E. O. Svensson, Niels Thygesen, Norbert Walter, and Charles Wyplosz.
The brieng papers and the full text of the hearing with the transcript of the questions
and answers are downloadable from the European Parliament Web site:
www.europarl.eu.int/comparl/econ/emu/default_en.htm.
Chapter 3
1. Blinder et al. (2001), for instance, argue that throughout 2001 the ECB has repeatedly
refused to endorse market anticipations that it would cut its interest rates. By the time
the ECB reduced rates by 25 basis points in May, the markets did no longer expect any
change.
2. In chapter 4 we will deal more extensively with the issue of transparency.
3. Still improvements to the HICP could be made. For instance, owner-occupied housing
costs could be included, see also Camba-Mendez (2003).
4. See Bernanke et al. (1999) for a good discussion of the experience of ination-
targeting countries.
5. It is often argued that the introduction of euro coins and banknotes raised the ina-
tion rate substantially. However, available ofcial data do not show a signicant impact
of the euro cash change-over on prices so far, although the estimated range has been
revised slightly up by Eurostat from 0 to 0.2 percent based on data for the rst half of
2002; the previous estimate was 0 to 0.16 percent. Still, unusually high price increases
did occur in some services (cafs and restaurants, health-related services, repairs, etc.)
and some regularly purchased low-priced goods. This might explain the public percep-
tion that the introduction of euro banknotes and coins had a large inationary impact
(European Commission 2002a).
6. For all these conceptual uncertainties and measurement problems, a specic numer-
ical ination target would represent an unhelpful and false precision. Rather price sta-
bility is best thought as an environment in which ination is so low and stable over time
that it does not materially enter into the decisions of households and rms. Remarks
by Chairman A. Greenspan on Transparency in monetary policy before the Federal
Reserve Bank of St. Louis, Economic Policy Conference, October 11, 2001.
7. For example, according to calculations of the Deutsche Bundesbank in 1998, the
consumer price index tends to overstate the effective ination rate by around 0.75 a
percentage point. See Deutsche Bundesbank, Monthly Bulletin, May 1998, p. 55.
8. As pointed out by Kumar et al. (2003), the costs of deation depend on the dea-
tionary source as well as on extent and duration. Deation may not entail signicant
costs and be accompanied by growth in output under certain circumstances. Among
these are temporary price declines due to overexpansion in aggregate supply caused by,
for instance, a productivity spurt or some other positive external shock. In those cases
deation is the manifestation of an adjustment to a new equilibrium in the context of
rising incomes.
9. Financial supervision and regulation in the euro area is even more decentralized. In
some countries banking supervision is carried out by the central bank, whereas in others
this task is performed by another institution, sometimes in close cooperation with the
central bank (see Oosterloo and De Haan 2003). The current setup has led to a discus-
sion about the proper role of the ECB in this regard (see Kremers et al. 2003 for an excel-
lent discussion). The ECB is not entrusted with any direct responsibility related to
prudential supervision of credit institutions and the stability of the nancial system. Also
scal policy-making in the euro area is decentralized. Still national scal policies are
restricted by the Stability and Growth Pact (SGP). There is an intense debate about the
question of whether rules like these are needed in a monetary union and, if so, whether
the rules of the SGP are the proper ones (see Eijfnger and De Haan 2000, Buti et al. 2002,
and De Haan et al. 2004 for a further discussion).
10. Problems of price measurement, remarks at the Annual Meeting of the American
Economic Association and the American Finance Association, Chicago, Illinois, January
3, 1998.
11. This part heavily draws on Ullersma (2002); see also Yates (2002).
12. Price level targeting may be a better way to anchor expectations as undershooting
of the target in the current period leads to inationary expectations in the next period
(Smets 2000).
13. In Akerlof et al. (1996) the model is based on nominal wage rigidity, while in Akerlof
et al. (2000) the mechanism is near rationality in the use of inationary expectations in
price and wage setting.
14. Another view in which nominal wage rigidity also plays a role is that a temporary
downturn can have persistent effects on unemployment due to hysteresis effects
Notes to Pages 3945 231
(Blanchard and Summers 1986). This can be explained in a number of ways. The unem-
ployed, because they lose human capital, may become less attractive to potential employ-
ers. Also, in an insideroutsider wage-setting framework, unions only take the interests
of the currently employed into account, so wages are set at levels that are too high. Issing
(2001b) argues for going to the root cause of the problem by structural reform.
15. Dickens (2001) points out some major weaknesses in the analysis of Wyplosz, for
instance, that the long-run Phillips curve is not necessarily stable.
16. According to Jaeger (2003), some ECB communication suggests that the second pillar
covers the higher business cycle frequencies of ination (in the short run), and that the
rst pillar provides a low-frequency crosscheck for the second pillar. By low frequency
Jaeger means cycles taking more than eight years to complete. However, certain ECB
communications suggest that the rst and second pillars both relate to the business cycle
frequencies.
17. This episode provides a good illustration of the discrepancy between what the ECB
does, and why, and how it is (wrongly) being reported. Gros et al. (2000, p. 2) write: It
is also interesting to note that the rst pillar (monetary growth) did not seem to play a
role in the ECBs April 1999 decision. In fact, at the time of the cut, the money supply
(M3) was expanding at about 5 percent, substantially above the target (sic) of 4.5
percent.
18. Koen et al. (2001) point out that the evolution of effective exchange rates was far from
uniform in the euro area. The depreciation in Belgium, for instance, was far less pro-
nounced than in Ireland. This is because Belgium trades widely with other euro area
countries, whereas Ireland trades mostly with the United Kingdom and the United
States. So the depreciation was more of a problem for Ireland than for Belgium, because
it was larger and because Ireland was ahead in the cycle (see also section 5.5).
19. As pointed out by Wyplosz (2003a), exchange rate changes can also indirectly affect
ination. A depreciation automatically increases the price of imported intermediate
goods. However, as long as there is some pass-through, a depreciation can improve trade
competitiveness, since with more exports and fewer imports, there is an improvement
of the current account. As world demand for domestic production increases, the level of
activity is stimulated and this exerts an upward inuence on prices and wages.
20. Figure 3.5 shows the case where CES utility is assumed. See Feenstra et al. (1993) for
further details.
21. This argument ts in with a branch of literature in which the microstructure of
nancial markets is used to describe the effects of sterilized foreign exchange market
interventions. Examples include Bhattacharya and Weller (1997) and Vitale (1999). See
Frenkel et al. (2001) for further details.
22. Other recent studies using another approach include Ito (2002), Kim (2003), King
(2003), Saacke (2002), Vitale (2003), and Taylor (2004).
23. This view goes back to Alchian and Klein (1973).
Chapter 4
1. Many authors, however, use the term transparency when they are in fact referring to
disclosure.
2. In contrast, Thornton (2002) argues that disclosure is neither necessary nor sufcient
for accountability. In his view, central banks are accountable to the public via elected
public ofcials. Consequently central bankers are accountable not only to these ofcials
for achieving the objectives, which they or the elected ofcials set, but also for the way
these objectives are being pursued. Secrecy to enhance the efciency of central banks
does not violate the principle of democratic accountability. Thornton argues that if dis-
closure diminishes policy effectiveness, accountability is not a justication for disclosure.
3. Of course, some of the information is directly transferred to the public, such as via
the Internet.
4. The remainder of this section heavily draws on Eijfnger and Geraats (2002).
5. See Geraats (2002) for an excellent survey of the literature on central bank
transparency.
6. Blinder et al. (2001) do not agree that publishing the model will enhance transparency.
They argue (2001, p. 3) that most central bank watchers will care only about the banks
basic view of how the economy works and how it thinks monetary policy affects output
and prices. Well-chosen words supplemented by a few key numbers may sufce. In fact,
they may convey the relevant information better than masses of equationswhich are
often far from transparent.
7. The Siklos index also includes the item special recognition of the role of nancial
system stability (on which the ECB gets a score of zero), which has little to do with dis-
closure. Finally, it seems that Siklos has made a mistake in coding for the element pub-
lication of a monetary policy strategy. While in his book he (rightly) states that the ECB
has published its strategy, in the coding the ECB receives a zero on this element.
8. Most indicators are based on activities rather than the contents of what is being
released. It is more important that the information be disclosed with clarity and that the
disclosure of data bring genuine understanding of monetary policy making to the public.
9. This discrepancy is not only evident in the total scores of the indicators but also in the
scores of various subgroups of issueslike objectives strategy and communication in our
index.
10. Hmlinen (2001) acknowledges this: It is true that we have not always been very
successful in our communication despite ambitious intentions. But communication is not
easy in a pan-European context in which differing cultures, languages, traditions and
motives affect how messages are interpreted by the different counterparties involved.
11. There is much research on the inuence of media on voting behavior. Biases in news
coverage can have a measurable impact on electoral preferences of voters near the center
of the political spectrum, since their political attitudes are often mixed, weakly held, or
nonexistent. See Gunther and Mughan (2000).
12. This part draws on De Haan and Eijfnger (2000) and De Haan et al. (1999). See also
Amtenbrink (1999).
13. For an earlier attempt to quantify accountability, see Briault et al. (1996). Another
indicator for central bank accountability is developed by Siklos (2002). See also Bini
Smaghi (1998).
14. The information reported by Fry et al. is based on a survey among of 94 central banks.
The index of transparency used by Cechetti and Krause is based on responses to three
questions relating to the degree and frequency at which each central bank provides
reports on its policy decisions, assessments about the state of the economy, and public
explanation of forecasts. The index is obtained as a simple average of these three crite-
ria. Independence is determined on the basis of the responses of ve questions (i.e., on
the importance of price stability, goal independence, instrument independence, govern-
ments reliance on central bank nancing, and term in ofce of the governor). Account-
ability is determined on the basis of the role of government in determining the
objective(s) of monetary policy and on monitoring by parliament and the government.
The index of credibility used by Cechetti and Krause (2002) is determined on the basis
of the difference between an assumed ination objective of 2 percent and expected ina-
tion, proxied by actual ination over the period 1985 to 1989.
15. Cukierman (2002) argues that the relationship between social welfare and the sacri-
ce ratio is not necessarily negative. A full welfare analysis should also take two other
considerations into account. First, a higher sacrice ratio also means that when mone-
tary policy is expansionary, it has a stronger positive impact on output, and second, the
permanent benets from stable prices.
16. Haupt and Waller (2000) examined whether the incorporation of WES data in econo-
metric models signicantly improves their ability to analyze and forecast economic
developments. Using survey data on ination, these authors determine that forecasting
models that incorporate WES survey data clearly outperform models that dont. The
obvious conclusion is that WES respondents had relevant information about future
developments.
17. We thank Alan Blinder for providing us with his survey.
18. We agree with the denition of credibility given by Cukierman and Meltzer (1986,
p. 1108): i.e., the absolute value of the difference between the policy makers plan and
the publics beliefs about those plans.
19. This has been calculated as follows: Using the IMFs classication of advanced
economies (WEO), we calculated average ination rates for the period from 1971 to 2000
(long term) and from 1990 to 2000 (medium term). For the long term, we obtained an
average ination rate of 7 percent, for the medium term of 3 percent. High-ination coun-
tries had above average ination in both periods.
Chapter 5
1. As of March 1, 2004, the staff of DG Economics numbered 159 and the staff of DG
Research 53, while the total staff of the ECB had increased to 1,231.
2. This one size does not t all problem can undermine political support for the
monetary union. Nitsch (2004) shows how ination differentials, which are clearly
related to differences in business cycle positions, can lead to dissolutions of currency
unions.
3. Their main aim is to test whether this voting behavior was inuenced by economic
differences across the German states. Therefore they rst examine to what extent the eco-
nomic situation in the various states was similar. Berger and De Haan (2002) nd that
there was considerable volatility of ination across states despite the fact that since late
1948 the D-mark circulated in all states under the sole rule of the Bundesbank. Interest-
ingly, despite an early trend toward convergence that lasted until the mid-1950s, ina-
tion differentials continued to exist during the entire sample period. Behind these dif-
ferences were, among other things, continued local and state autonomy in scal matters
as well as considerable variation in the underlying economic structure. There were also
large differences between growth rates of real GDP of the various states, which proved
to be quite persistent.
4. Heinemann and Huefner (2002) have estimated reaction functions for the ECB. As
there are no voting records for the ECB Governing Council, these authors had to rely on
indirect ways to examine whether diverging economic developments in the euro area
have affected ECB policy making. In their ordered probit model, Heinemann and
Huefner nd that the difference between the euro area average and the median of the
ination and output gap is signicantly different from zero, though only at the 10 percent
level.
5. Presidents of regional central banks were nominated by the governments of the
concerned Lands, while members of the Executive Board of the Bundesbank were
nominated by the federal government.
6. Also note the similarity in the political backgrounds of the appointing government
and the appointee.
7. Berger and De Haan (2002) show that the economic differences between the German
states in their sample period are of the same magnitude as the current economic differ-
ences between the countries in the euro area.
8. Furthermore Carlino and DeFina (1998) showed that output sensitivity to monetary
policy shocks differs signicantly across US regions, which is explained by the concen-
tration of small rms and the share of manufacturing in total production.
9. In writing this section, we drew heavily on Massmann and Mitchell (2003).
10. We will focus on studies analyzing the synchronization of business cycles in the euro
area. For references to other studies, see Massmann and Mitchell (2003); see also the
homepage of Euro Area Business Cycle Network (http://www.eabcn.org).
11. However, Agresti and Mojon (2001) nd that the business cycle uctuations of GDP,
consumption, and investment of most euro area countries were, even before stage three
of EMU, highly synchronized with uctuations in the euro area.
12. Wynne and Koo (2000) show that the cross-correlations among the business cycles
(of GDP, prices, or employment) of the 12 US Federal Reserve districts are much higher
than the cross-correlation of the business cycles of the 15 EU countries. Also Clark and
van Wincoop (2001) report that business cycles of US Census regions are substantially
more synchronized than those of EU countries, both over the past four decades and the
past two decades.
13. A simple OLS regression of cyclical correlation on trade intensity may be inappro-
priate. Countries may, for instance, choose to link their currency to that of their most
important trading partners; the resulting closeness of policies creates a positive associa-
tion of business cycles in these countries. Frankel and Rose (1998) therefore use instru-
mental variables (IV). They use distance, adjacency, and common language dummies as
instruments, based on the success of these variables in explaining trade (in gravity equa-
tion models) and the presumption that they are otherwise unrelated to the business
cycle. The IV estimates of Frankel and Rose are as much as three times the size of the
corresponding OLS estimates. However, Gruben et al. (2002) argue that neighboring
countries with a similar language may be more disposed toward similar monetary poli-
cies. So the instruments that Frankel and Rose use may ultimately be seen as capturing
the effects of various inuences, and thereby upwardly biasing the estimated impact of
trade alone. A statistical test for overidentifying restrictions conrms this. Gruben et al.
abandon IV estimation in favor of OLS and incorporate the instruments used by Frankel
and Rose into the system as independent variables. This yields point estimates that are
some 50 percent lower than those reported by Frankel and Rose (1998).
14. Frankel and Rose (2002) combine estimates of the trade-creating effects of common
currencies with evidence of a link between trade and growth. Their results suggest that
some countries could increase their per capita income by 20 percent over 20 years by dol-
larizing or adopting the euro.
15. The countries are Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Greece, Ireland, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, the
United Kingdom, and the United States.
16. Interestingly, the standard deviation of ination rates across countries after the intro-
duction of the euro is not much different from the levels reported among German states
after the introduction of the D-mark. In 19992001, the average standard deviation of
ination rates in the euro zone is 0.87. This closely matches the 195051 average stan-
dard deviation of ination rates across German states of 0.88 as reported by Berger and
De Haan (2002).
17. Kieler (2003) provides some illustrative calculations of how average ination rates
may differ across euro area countries over the next 10 to 20 years, depending on how
fast the remaining differences in price levels are reduced. His results suggest that the
inationary trend may vary from 1.25 percent in Germany and France to 2 to 3.25 percent
in Greece, Portugal, and Spain.
18. The results of von Hagen and Hoffman (2003) suggest, however, that aggregate
demand in the euro area countries is determined by the euro real interest rate, while the
national real interest rate differentials do not appear to have a signicant effect on
national output gaps. This conclusion is based on estimates of a simple backward-looking
IS-curve in which the ex post real interest rate, the real effective exchange rate, and the
US output gap are the regressors for the output gap in the euro area countries.
19. The complete results have been published in the Working Papers 91114 of the ECB.
See especially Mojon and Peersman (2001) and Angeloni et al. (2001). For a discussion
of the results of simulations with econometric models of national central banks, see Van
Els et al. (2001).
20. For a further discussion, see also Eijfnger and De Haan (2000) and Kieler and
Saarenheimo (1998).
Chapter 6
1. For extensive surveys, we refer to Eijfnger and De Haan (1996) and Berger et al.
(2001a).
2. Surveys of the early empirical research on CBI in transition economies can be found
in Maliszewski (2000) and Wagner (1999).
3. The index of Grilli et al. (1991) is based on 16 criteria, relating to economic and
political independence.
4. Wagner (1999) argues that as long as CBI is only legal, meaning that it only exists
on paper, it will not only be ineffective but may even be counterproductive as further
institutional reforms then become necessary.
5. The earlier study was published under the authors previous name (Riesinger).
6. Some observers have argued in favor of euroization: the acceding countries adopt the
euro as their national currency without being members of the euro area. However, uni-
lateral euroization has been ruled out by the Econ as it would run counter to the under-
lying economic reasoning of EMU in the [EU] Treaty, which foresees the eventual
adoption of the euro as the endpoint of a structured convergence process within a mul-
tilateral framework (Econ 2000).
7. Natalucci and Ravenna (2002) use a model calibrated for the Czech Republic and show
that monetary policy and the choice of exchange rate regime alone do not necessarily
allow compliance with the EMU accession requirements if the Balassa-Samuelson effect
is at work. Even in the absence of any business cycle shock and with full credibility,
monetary policy is unlikely to ensure that the levels of ination and exchange rate are
stabilized within the required bounds.
8. Also some studies exist that refer to just one country; see Iara and Traistaru (2003) for
a discussion.
9. In summarizing the results of this study, we only consider coefcients that are
signicantly different from zero.
10. The Grubel-Lloyd index is dened as follows: 100
*
(1 - (sum, all sectors |(export,
per sector - import, per sector)|/sum, all sectors(export, per sector + import, per
sector))).
11. See Rose (2004) for a summary of the (huge) literature on the effects of currency union
on trade.
12. Fidrmuc and Korhonen (2004) report a high correlation between supply and demand
shocks in the new member countries and the Europeans share in their exports and
imports. They also nd signicant correlations of both supply and demand shocks with
the levels of intra-industry trade. In contrast, they nd only low correlation of GDP per
capita with both types of shocks. Thus the level of economic development of the coun-
tries does not seem to inuence the synchronization of business cycles.
13. For an earlier paper following a similar line of argument, see Boone and Maurel
(1998), who calculate correlation coefcients between the cyclical components of indus-
trial production and unemployment rates for seven new member countries against
Germany and the European. They report a relatively high degree of business cycle
correlation for the new member countries with Germany. A related study is Boone and
Maurel (1999).
14. The weighted average of the demand and supply shocks coefcients of correlation
are 0.24 and 0.52 for the euro area countries and 0.13 and 0.11 for the new member coun-
tries. Malta and Cyprus are not included in the Fidrmuc and Korhonen (2003) sample.
15. We thank Fidrmuc for providing the detailed gures of Firdmuc and Korhonen
(2004). Spel (2003) does not provide the details of the calculations, and they are there-
fore not included in the table.
16. Ganev et al. (2002) and Elbourne et al. (2003) provide reviews of the literature on the
topic.
17. See Golinelli and Rovelli (2002) for a good example of a recent small structural model
for Hungary.
Chapter 7
1. This part heavily draws on Berger (2002) and Berger et al. (2003).
2. Aproposal along these lines has been put forward by Horn (2003). Horn suggests that
the countries be aligned in eight groups. The rst group (with four votes) would be com-
prised of those four countries with the largest weight according to share of GDP and the
share of population. In the second group would be the three countries next in the ranking
of economic strength. This group has three votes. The remaining member states would
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References 259
Accountability of the European Central
Bank, 10812
Acquis communautaire, 170, 180
Asset price ination, 7478
Balassa-Samuelson effect, 4243, 15358,
201205, 226
Blinders survey on credibility, 11217
Boskin Report, 40
Business cycles
differences and ination, 15860
implications of enlargement of the
monetary union, 192201
synchronization, 13748, 192201,
22627
trade relationships and, 18889
Central bank governor turnover rate,
17276
Central bank independence (CBI), 17077
Code of Good Practices on Transparency
in Monetary and Financial Policies of
the IMF, 34
Consumer spending
asset price ination and, 7477
patterns, 14950
Convergence criteria, 17779
Credibility
Blinders survey on, 11217
of European Central Bank, 11723
Currency boards, 18083
Decentralization
diverging business cycles and, 13748
risks of, 13037
structure of the European Central Bank,
58, 12528
Decision making by the European
Central Bank, 13335
Deationary policy, 3947
Delors, Jacques, 2
Delors Committee, 2
Demand
money, 56
shocks, 19698
Dependence on trade, 150
Deposit facility, 15
Disclosure
accountability and, 10812
economic, 86, 8990
effects of, 9294
operational, 9192, 9899, 102103,
105
policy, 86, 91
political, 85, 8789, 94, 9697
procedural, 86, 9091, 9798
various facets of, 8587
Economic and Monetary Union (EMU),
the, start of, 12
Economic disclosure, 86, 8990
Economist, The, 5
EONIA (Euro Over-Night Index
Average), 15
Euro, the
and dollar exchange rate, 5863, 104
exchange rate pass-through (ERPT),
5963
external value of, 5774
interventions in exchange rates of,
6374
Over-Night Index Average (EONIA),
15
trade enhancing effect of, 189
Index
262 Index
European Central Bank (ECB). See also
Monetary policy, European Central
Bank
accountability of, 10812
centralization of, 21516
credibility of, 11723
decentralized structure of, 58
decision making by, 13335
Executive Board, 11
favorable assessment of, 225
General Council of, 11
Governing Council, 3, 5, 9, 1011, 1314,
18, 5657, 21314
ination targeting by, 22526
interest decisions by, 1619
Lombard facility, 15
marginal lending facility, 15
minimum reserve system, 16
money market, 15
M3, 1218, 4756
new EU members and, 67
newspaper reports on, 106107
political independence of, 9, 22122
political weight of members of, 21314
reform options, 21523
research output of, 129
standing facilities, 15
start of, 12
structure of, 1011
transparency of, 35
European Forecasting Network, 19394
European Monetary Institute, 56, 137
European Union, new members of the,
67, 16970
business cycle synchronization by,
192201
central bank independence and, 17077
currency boards and, 18083
implications of, 192209
ination among, 201205
Maastricht criteria for, 177, 17983
monetary transmission and nancial
structure in, 205209
optimal currency area theory and,
18392
quick entry for, 226
Exchange market interventions, 18, 6374
Exchange rate
optimal currency area theory and,
18392
pass-through (ERPT), 5963
as source of shocks, 190
Exchange Rate Mechanism (ERM), 2, 6,
17879
Executive Board of the European Central
Bank, 11
Expectations, nancial market, 3236
Federal Reserve Bank, US, 5, 94, 96, 122,
126, 130
Financial market indicators, 13
expectations according to newspaper
reports, 3236
Financial Times, The, 106107
First pillar of monetary policy strategy,
1213, 4756
Forecasts, ination, 5657
Forward rates, analysis of, 2832
General Council of the European Central
Bank, 11
Governing Council, European Central
Bank, 3, 5, 9, 1011, 1314
and Boskin Report, 4041
decentralization and, 126, 128, 13132
decisions on interest rates, 1819
evaluation of monetary policy strategy
by, 2125
ination forecasts by, 5657
options for reform of, 21517
reforms proposed by, 21922
rotation, 21920
structure of, 21314
voting structure reform of, 21719
Greenspan, Alan, 40, 43
Harmonized Index of Consumer Prices
(HICP), 23, 1112, 13, 204
eurodollar exchange rate and, 5859
price index and, 3739
Ination, 12, 1314
asset price, 7477
Balassa-Samuelson effect on, 4243,
15358, 201205, 226
below 2 percent, 3947
central bank independence and, 173
differentials in the euro area, 14860
forecasts, 5657
measurement bias in, 4041
monetary policy effect on, 16367
money growth and, 5455
new EU members and, 201205
objective of price stability policy, 3647
Index 263
Policy Target Agreement (PTA) and, 109
price index calculation of, 3739
price level convergence and, 15153
targeting, 22526
temporary differentials in, 4243
transparency and, 8889, 9394
wages and unemployment and, 4447
Integration
nancial, 14647
monetary, 14445, 22627
Interest rates
forward rates and, 2832
monetary policy and, 1621
stepping versus smoothing, 7880
Interregional migration, 188
Interventions, eurodollar exchange rate,
6374
Issing, Otmar, 4, 2122
Labor market indicators, 13
Lafontaine, Oskar, 16
Lombard facility, 15
Maastricht Treaty, 2, 5, 9, 11, 169, 177,
17983
Marginal lending facility, 15
Measurement bias, 4041
Minimum reserve system, 16
Monetary policy, European Central Bank.
See also European Central Bank (ECB)
criticism of, 27
diverging business cycles and, 13748,
22627
effects on output and ination, 16367
evaluation of, 2125
exchange rate pass-through (ERPT) and,
5963
expectations according to newspaper
reports, 3236
interest rates and, 1621
money demand and, 56
money growth pillar in, 1213, 4756
pass-through of, 16163
predictability of, 2736
responsibilities, 28
strategy, 1116
transmission and nancial structure,
differences in, 16065, 205209
two pillars of, 1214, 4756, 57
Money growth, 1213, 4756
M3, 1213, 4756
Newspaper reports, 3236, 106107
Open market operations, 1516
Operational disclosure, 8687, 9192,
9899, 102103, 105
Optimal currency area theory,
endogeneity of OCA criteria, 18392
Output, monetary policy effects on,
16367
Pass-through of monetary policy
decisions, 16163
Pillars of monetary policy, 1214, 4756,
57
Policy disclosure, 86, 91
Policy Target Agreement (PTA), 109
Political disclosure, 85, 86, 8789, 94,
9697
Political independence of the European
Central Bank, 9, 22122
Predictability of ECB policy decisions,
2736
Price
Balassa-Samuelson effect and, 15358
index, 3739
level convergence, 15153
stability, 23, 1112, 1314, 19
ination objective of, 3647
Procedural disclosure, 86, 9091, 9798
Renancing operations, 1516
Reform of European Central Bank
to increase centralization, 21517
options for, 21519
political independence and, 22122
2002 proposal for, 22023
to reduce overrepresentation of some
members, 21314
rotation, 21819
voting, 21718
Research output of European Central
Banks, 129
Risks of decentralization, 13037
Rotation, European Central Bank
Governing Board, 21819
Second pillar of monetary policy strategy,
1314
Shocks, demand and supply, 19698
Specialization and business cycle
synchronization, 144
Standing facilities, monetary policy, 15
264 Index
Stepping versus smoothing, interest rate,
7880
Structure of the European Central Bank,
1011
Supply shocks, 19698
Synchronization, business cycle, 13848,
192201, 22627
Taylor rule, 44
Transmission, monetary policy, 16065,
205209
Transparency of the European Central
Bank, 35
denition of, 83
effects of disclosure on, 9294
importance of, 8385
objectives and indexes of, 94107
various facets of disclosure and, 8594
Treaty on European Union (TEU), 109
Two-pillar strategy of the European
Central Bank, 1214, 24
Vector autoregressions (VARs), 205207
Wages
effect of ination on, 4447
exibility in new EU member countries,
18586
World Economic Survey, 117
Zero bound, 4344

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Condence indicators. Among these are the economic sentiment

Indicators for the labor market. Employment and unemployment in the

Financial market indicators. To this group of indicators belong various

Projections for ination and economic activity. The Governing Council

There can be an upward measurement bias in ination.

There is less risk of deation.

The Balassa-Samuelson effect calls for a higher ECB ination

It can create more room to stabilize the economy.

Ination tends to grease the economy.

Rumors and speculation of euro support intervention

Statements by ofcials in support of the euro

Statements by ofcials not supportive of the euro

Firm reports of intervention

Input (raw data) Central bank strategy Output (decisions)

Communication about strategy (disclosure)

Publics understanding (transparency) Behavior

Is there a formal statement of the objective(s) of monetary policy, with

Is there a quantication of the primary objective(s)?

Are there explicit institutional arrangements or contracts between the

Is the basic economic data relevant for the conduct of monetary

Does the central bank disclose the formal macroeconomic model(s)

Does the central bank regularly publish its own macroeconomic

Does the central bank give a comprehensive account of policy delib-

Are decisions about adjustments to the main operating instrument or

Does the central bank provide an explanation when it announces

Does the central bank disclose an explicit policy inclination after

Does the central bank regularly provide information on (unantici-

Does the central bank regularly provide an evaluation of the policy

The survey results indicators were valuable in explaining global eco-

The results were suitable for use in forecasting economic develop-

The number of participants in the survey, which varied from country

A credible central bank can reduce ination at lower social cost.

A credible central bank is better able to maintain low ination once

A credible central bank can more easily change tactics or operation

A credible central bank can more easily defend a countrys currency

Credibility is important as a way to justify public support for an inde-

The central bank should have a high level of independence.

The central bank should be open and transparent.

The central bank should have a history of ghting ination.

The central bank should be bound (by law or by custom) to follow a

European Central Bank

Publication record. How many scientic journal articles have been

Average tradables ination as described by equation (8) will, in general,

Actual stabilization policy will, as a rule, not be optimal. In particular, it

The need to enhance CBI (with particular reference to monetary

The desire to foster the collective nature of the NBP management

The European Treaty, which commits Poland to coordinate its domes-

the budget decit is higher than 3 percent of GDPunless either the

the ratio of gross government debt to GDP exceeds 60 percent

The imported foreign monetary policy is in the hands of an inde-

The home countrys central bank is relatively dependent and output-

The correlation between the home and foreign countrys output

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