European Central Bank – hit them when they’re down?

With the CIE and NCEA exam fast approaching there is usually a question that refers to economic policy in economies. Monetary and Fiscal Policy are two that are covered in significant detail and you will be aware of the following:

Monetary Policy – the way in which interest rates and money supply are used to manage the overall level of economic activity and achieve government targets for inflation, unemployment, economic growth and balance of payments.

Fiscal Policy – the use taxes and spending by the government to manipulate aggregate demand and influence the overall economic activity in the economy.

It is puzzling to observe the implementation of monetary policy by the European Central Bank when you consider the correlation between the interest rates movements and the economic environment in the euro area. I have put together a flow diagram below that shows the steps taken by the ECB since 9th July 2008.

* 9th July 2008 ECB IR↑= 3.75% – Just before finaincial crisis – ECB concerned about inflation
* 21st Jan 2009 ECB IR↓ = 2% – Sept 2008 – global economy collapses and inflation not an issue
* 13th April 2011 ECB IR↑ = 1.25% – Europe – high unemployment, low growth, debt crisis. ECB raises interest rates?
* 13th July 2011 ECB IR↑ = 1.50% – Debt crisis worsens and no growth. ECB raises interest rates again?
* Austerity measures – slash gov’t spending and raise taxes = little or no growth.

The euro zone’s concerns are that debts levels are too high and economic growth is too low. But are the debt levels this large because of too slow growth or the fact that some countries don’t have an efficient tax collection system – eg. Greece? When you relate the ECB policy with that of the US Federal Reserve there are differing opinions on how to use monetary and fiscal policy.

US Fed Model
Expansionary Fiscal Policy – extension in unemployment benefits and temporary tax breaks for low and middle-income households.
Expansionary Monetary Policy – low interest rates and quantitive easing.

ECB Model
Contractionary Fiscal Policy– strong austerity measures
Contractionary Monetary Policy – higher interest rates

The ECB might be concerned with dampening inflation but with the CPI at 2.5% prices are not really unstable. Are they repeating the mistakes of the early 1930’s? Then the tight monetary policy and austerity measures led to the Depression. Furthermore it appears that neither the policies of the US Federal Reserve nor the ECB are actually working.

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