2: European Central Bank and Monetary System (Monetary Policy objectives and targets)

In 1994 the European Monetary Institute was created as transitional step in establishing the European Central Bank. (ECB) and a common currency. The ECB, which was established in 1998, is responsible for setting a single monetary policy and interest rate for the adopting nations, in conjunction with their national central banks. Late in 1998, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain cut their interest rates to a nearly uniformly low level in an effort to promote growth and to prepare the way for a unified currency. At the beginning of 1999, the same EU members adopted a single currency, the euro,. for foreign exchange and electronic payments. (Greece, which did not meet the economic conditions required until 2000, subsequently also adopted the euro.) The introduction of the euro four decades after the beginings of the European Union was widely regarded as a major step toward European political unity. By creating a common economic policy, the nations acted to put a damper on excessive public spending, reduce debt, and make a strong attempt at taming inflation. However, the budget-deficit ceilings established in the process of introducing the euro have been violated by a number of countries since 2001, in part because of national government measures to stimulate economic growth. In 2003, EU finance ministers, faced with the fact that economic downturns had put France and Germany in violation of the ceilings, temporarily suspended the pact. The European Commission challenged that move, however, and the EU high court annulled the finance ministers' decision in 2004. Euro coins and notes began circulating in Jan., 2002, and local currencies were no longer accepted as legal tender two months later. The European Currency Unit (ECU), which was established in 1979, was the forerunner of the euro. Derived from a basket of varying amounts of the currencies of the EU nations, the ECU was a unit of accounting used to determine exchange rates among the national currencies.

Objective of monetary policy

To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1). "Without prejudice to the objective of price stability", the Eurosystem shall also "support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union". These include inter alia "full employment" and "balanced economic growth". The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment. These Treaty provisions reflect the broad consensus that

the benefits of price stability are substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a crucial precondition for increasing economic welfare and the growth potential of an economy . the natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy.

The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into account the broader economic goals of the Union. In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.

Monopoly supplier of monetary base

The Eurosystem is the sole issuer of banknotes and bank reserves in the euro area. This makes it the monopoly supplier of the monetary base, which consists of

currency (banknotes and coins) in circulation, the reserves held by counterparties with the Eurosystem, and recourse by credit institutions to the Eurosystems deposit facility.

These items are liabilities in the Eurosystems balance sheet. Reserves can be broken down further into required and excess reserves. In the Eurosystems minimum reserve system, counterparties are obliged to hold reserves with the national central banks (NCBs). Beyond that, credit institutions usually hold only a small amount of voluntary excess reserves with the Eurosystem. By virtue of its monopoly, a central bank is able to manage the liquidity situation in the money market and influence money market interest rates.

Signalling the monetary policy stance

In addition to steering interest rates by managing liquidity, the central bank can also signal its monetary policy stance to the money market. This is usually done by changing the conditions under which the central bank is willing to enter into transactions with credit institutions.

Ensuring proper functioning of the money market

In its operations, the central bank also aims to ensure a proper functioning of the money market and to help credit institutions meet their liquidity needs in a smooth manner. This is achieved by providing both regular refinancing to credit institutions and facilities that allow them to deal with end-of-day balances and to cushion transitory liquidity fluctuations.

Guiding principles
The operational framework of the Eurosystem is based on the principles laid down in the Treaty on the Functioning of the European Union. Article 127 of that Treaty states that in pursuing its objectives, the Eurosystem "() shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources ()". In addition to the principles set out in the Treaty on the Functioning of the European Union, the operational framework follows several guiding principles. Operational efficiency The most important principle is operational efficiency. It can be defined as the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level. Equal treatment and harmonisation Another principle is that credit institutions must be treated equally irrespective of their size and location in the euro area. The harmonisation of rules and procedures helps to ensure equal treatment by trying to provide identical conditions to all credit institutions in the euro area in transactions with the Eurosystem. Decentralised implementation One principle specific to the Eurosystem is the decentralised implementation of monetary policy. The ECB coordinates the operations and the national central banks (NCBs) carry out the transactions. Simplicity, transparency, continuity, safety and cost efficiency Simplicity and transparency ensure that the intentions behind monetary policy operations are correctly understood. The principle of continuity aims at avoiding major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystems financial and operational risks are kept to a minimum. Cost efficiency means keeping low the operational costs to both the Eurosystem and its counterparties arising from the operational framework.

Benefits of price stability

The objective of price stability refers to the general level of prices in the economy. It implies avoiding both prolonged inflation and deflation. Price stability contributes to achieving high levels of economic activity and employment by

improving the transparency of the price mechanism. Under price stability people can recognise changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently; reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest; avoiding unproductive activities to hedge against the negative impact of inflation or deflation; reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behaviour of tax and social security systems; preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation; and contributing to financial stability.

The Eurosystem's instruments The operational framework of the Eurosystem consists of the following set of instruments:

open market operations, standing facilities, minimum reserve requirements for credit institutions.