European Central Bank Monetary Policy: Literature Review Part 2

Evaluate the actions of the European Central Bank in the conduct of Monetary Policy, describing the main strategies and tools used to stabilise the Euro currency (Literature Review)



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Unconventional instruments of the ECB monetary policy

These operations entail reverse transactions against collateral in an attempt to reduce possible risks to the central bank’s balance sheet. The central bank banks on the distribution functions of the financial system to move the monetary stance into even broader financial settings. Nonetheless, because policy rates are usually bound near or at zero, this reduces the levels of monetary stimulus that the central bank can achieve via rate cuts alone (Financial Times, 2009). Central banks find it almost impossible to target such a rate and hence opt for alternative operations. This has seen the ECB for example turn to unconventional policy, a move that has been motivated by the emergence of difficult turmoil in credit markets. Unconventional instruments are essential during abnormal economic conditions because, at such a time, the conventional instruments may not be sufficient to enable the ECB to attain its set objectives. This is the case, according to Pattipeilohy et al. (2013) because some economic shocks can be so powerful that it becomes necessary to reduce the nominal interest rate to zero. This unconventional monetary policy can be realised in one of the following three ways: (i) through the steering of expectations for both long-term and medium-term interest rates; (ii)through credit easing, which entails alteration of the contents of the central bank’s balance sheet; and (iii) through quantitative easing which entails expanding the balance sheet of the central bank. Meier (2009) has defined unconventional monetary policies as a group of operations that utilise the balance sheet of the central bank with a view to directly impacting a diverse set of asset prices, market rates, and lending amounts. Accordingly, unconventional monetary policies are an attempt to improve and/or short-circuit the normal conveyance “from market rates into financial conditions facing the wider economy” (Meier, 2009, p. 6).

Policy Implications

Based on the foregoing discussion, it is rather apparent that while the ECB monetary analysis hinges on the NCM framework, we still have a key difference in regard to how monetary aggregates are treated (Arestis and Sawyer, 2013). In this respect, the ECB’s monetary policy varies from those of the NCM with regard to the associated implications. Put simply, “ECB monetary policy is not strictly speaking of the inflation targeting type” (Hein and Stockhammer, 2011, p. 200). This is especially true, according to Arestis and Sawyer (2013) with regards to the ‘two-pillar’ approach, which hardly pays any attention to monetary aggregates, unlike the NCM.  The two-pillar approach has been reported to send contradictory and somewhat different signals at a more frequent rate that is ordinarily acceptable, and this raises questions regarding its credibility (CEPS, 2005). At the same time, there is some truth in the assertion that the ECB endeavours to place a lot of significance on monetary aggregates, and this too, has acted as a source of additional criticism of the ECB Monetary policies.

Woodford (2006) endeavours to provide a thorough critique of the monetary approach of the ECB by opining that the ECB Monetary analysis does not have a theoretical foundation. Other scholars (for example, Begg et al., 2002; De Grauwe and Polan, 2005) have also proposed that money does not act as a reliable indicator of inflation considering that it is often characterised by constant shifts in velocity. This in turn makes it hard to justify the focus of the ECB’s monetary policies solely on the basis of price stability. Angeriz and Arestis (2007) note that there are many examples of historical economic developments where economies achieved price stability followed by an episode of macroeconomic instability.  Such examples serve as an indication that price stability often precedes undesirable economic performance. For example, the early 2000s was a period of relative price stability in the Eurozone economic market, but these years laid the foundation for the economic crisis that affected the economies in this region and other world economies starting from August 2007.

The ECB reports that “over the longer term, monetary policy can only influence the price level in the economy; it cannot exert a lasting impact on economic activity” (2008, p. 34). However, such an assertion rarely follows reality. For example, Arestis and Sawyer (2008) advance the argument that the macro-econometric model upon which the ECB monetary policy rests does not appear to support this assertion.  Arestis and Sawyer (2008), by drawing on empirical evidence for various pertinent macro-econometric models by the ECB, point towards a comparatively weak impact on interest rate variations on inflation. According to Hein and Stockhammer (2011), monetary policy could result in long-run implications on real magnitudes, something that is not in line with the current theoretical framework of the ECB monetary policy.

Arestis (2015) is of the view that the ECB economic analysis acts as an evaluation of developments in price along with the risks involved in price stability over both the medium and short terms. The range of indicators encompasses “developments in overall output; aggregate demand and its components; fiscal policy; capital and labour market conditions; a broad range of price and cost indicators; developments in the exchange rate; the global economy and the balance of payments; financial markets; and the balance sheet positions of euro area sectors” (ECB, 2004, p. 55). As such, the ECB economic analysis gives us a glimpse into the risks to price stability and developments in price over the medium and short term from a broad perspective (Arestis, 2015). The aforementioned factors, along with the evaluation involved, are useful in the determination of real activity dynamics, as well as the likely price developments from the point of view of the association between demand and supply of services, goods, and factors of the market over shorter time horizons (ECB, 2008). Another focus of the ECB monetary policy is on the monetary developments for relevant information regarding the projected price developments in both the medium and long term. By focusing on the long term, the ECB monetary approach is essentially seeking to take advantage of the long-run association between prices and money (ECB, 2004). According to the ECB (2008), such an approach is desirable for it is deemed as being “sufficient to hedge against the risks of both very low inflation and deflation” (p. 35). According to Issing (2003), any deviation from the documented reference value of 4.5% relative to the M3 monetary growth is not desirable as it would be an indication of possible risks to price stability. Issing (2003) further opines that the ECB makes use of monetary analysis to verify consistency between economic analyses, on the one hand, the short-term outlook and the other hand, the long-term outlook.

The rationale for the ECB’s reliance on the “two-pillar” approach hinges on the hypothetical assumption that monetary policy entails various time perspectives that demand a different approach for each case. The short-to medium-term perspective calls for a focus on economic analysis, whereas the long-term price trends perspective calls for monetary evaluation, along with a strong conviction in the long-term association between inflation and money (Arestis, 2015). Such an approach is a demonstration of the idea that inflation ought to be dealt with by manipulating the interest rate as well as by watching the movements made by the M3.  While volatility is permissible in the short-term, it is not tolerable in the long run, and this acts as a further demonstration of the impact of monetary policy on prices characterised by a long lag.


The main responsibility of the ECB is to administer the monetary policy among EU member states. It does this on the basis of two main pillars. First, the ECB while implementing monetary policy aims to determine the interest rate that is desirable in order to realise price stability. Also known as the rate of inflation, this monetary policy seeks to secure inflation expectations on the basis of a dependable and methodical technique.  The second pillar hinges on an operational framework that encompasses the different procedures and instruments that the ECB needs in order for it may achieve its set interest rate. While the two-pillar approach has been touted as beneficial in enabling he analysing of the medium to long-term association between money and prices, it has also come under criticism in that it sends contradictory and varied signals that would ordinarily be acceptable, thus raising the issue of credibility. Some of the conventional instruments that the ECB relies on in order to achieve its objectives include OMOs that influence short-term interest rates and avail money to the banking system. The ECB also sets the deposit rate and marginal lending rates. The ECB may also opt for quantitative easing in order to avail money to banks so that they can use it to buy new assets like bonds and shares. However, the ECB may also opt for unconventional instruments in order to achieve its set objectives, especially when faced with unusual economic conditions. This is because, at such times, the use of conventional instruments alone is not enough.


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