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The start of the European monetary union gave additional impetus to the lively debate on the effects of monetary policy and the appropriate strategy for central banks. This book collects papers and comments by leading academics and central bankers such as O.Issing, M.King, B.McCallum, A.Meltzer, L.Svensson and H.Tietmeyer. The volume examines methodological questions, the actual role played by the financial sectors and labour markets in implementing monetary policy in Europe, and the likely future developments in these areas.




The debate on the monetary transmission process has not only continued in the past few years but has also intensified. There are a number of reasons for this. In academic circles there are still various different approaches that seek to explain how monetary policy influences an economy. More and more areas have come to be included in the analysis which attracted less attention in the past. Thus, nowadays — on the basis of an improved microeconomic theory — more attention is being paid to the role of financial intermediaries and financial systems in general than was previously the case.
Heinz Herrmann

1. Analysis of the Monetary Transmission Mechanism: Methodological Issues

The purpose of this chapter is to consider several methodological issues relevant for study of the monetary transmission process. These issues involve relative emphasis on monetary shocks as opposed to systematic policy adjustments; vector autoregression versus structural modelling research strategies; impulse response versus vector autocorrelation functions as diagnostic tools; and an evaluation of the so-called ‘narrative approach’. But while these methodological issues are stressed, the chapter’s approach is significantly substantive, in the sense that the issues will be considered in the context of a non-trivial quantitative analysis that is intended to be of interest on its own.
Bennett T. McCallum

2. Price Stability as a Target for Monetary Policy: Defining and Maintaining Price Stability

The purpose of this chapter is to provide an up-to-date discussion of monetary policy with ‘price stability’ as the primary objective. The chapter discusses how ‘price stability’ can be defined, and how price stability can be maintained in practice. It also discusses some lessons for the Eurosystem.
Lars E. O. Svensson

3. The Transmission Process

I must confess some vested interests in this topic. I first discussed it in a paper with Karl Brunner, more than thirty-five years ago (Brunner and Meltzer, 1963). I have returned to the topic many times, most recently in a published symposium (Meltzer, 1995). I will refrain from reviewing these earlier studies, although I will refer in passing to some of the main ideas. I will concentrate on two topics. They do not exhaust the subject, but they raise issues that I believe are central.
Allan H. Meltzer

4. Asymmetric Interest Rate Policy in Europe: Causes and Consequences

The recent theoretical and empirical literature on monetary policy rules has increasingly focused on short-term interest rates rather than monetary aggregates for studying European monetary policy issues. There are several reasons for this: first, as in the United States, monetary aggregates in Europe have displayed a less obvious link to real economic activity and inflation during the 1980s and 1990s as opposed to the 1960s and 1970s. Second, many central banks have de-emphasised the role of monetary aggregates and have moved to operating procedures that focus more on interest rates (i.e. the Fed funds target rate in the United States) or inflation rates (i.e. the inflation targets in the United Kingdom, Canada, or New Zealand). Following the paper by Taylor (1993) and more recent applications by Clarida and Gertler (1997), Clarida, Gali and Gertler (1997, 1998), Gerlach and Smets (1998), Kuttner and Posen (1998) and Rudebusch and Svensson (1998) there is now a growing literature on so-called ‘interest rate smoothing’ rules for Europe.1 These papers use a simple policy reaction function in which interest rate adjustment towards equilibrium depends on the deviations of inflation and output from their respective target values. It is shown that such policy reaction functions fit the data quite well.
Axel A. Weber

5. Legal Structure, Financial Structure and the Monetary Policy Transmission Mechanism

Over the past decade, the countries of central Europe have become more alike in many ways. As the new members of the European Monetary Union (EMU) prepared for the birth of the Euro on 1 January 1999, their economic policies became substantially more uniform. All eleven countries in the new Euro Area had virtually eliminated inflation and taken serious steps toward fiscal consolidation.2 As their monetary and fiscal policies have adjusted to meet these common goals, the countries’ business cycle fluctuations appear to have become more synchronised as well.3 While this makes the job of the European System of Central Banks (ESCB) easier, numerous difficult challenges remain. Primary among these is the making of policy in the face of the possibility that it will have differential impacts across the countries of the Euro Area.
Stephen G. Cecchetti

6. Differences Between Financial Systems in European Countries: Consequences for EMU

There are three main issues which must be discussed if one wishes to answer the question which this chapter addresses:
Which features of a financial system are important for monetary policy or, in other words, how is monetary policy conducted, and how does it affect the real economy, and how and to what extent does this depend on the specific features of an economy?
How different are the financial sectors — or more generally the financial systems — in Europe?
If significant differences existed between countries, would this have consequences for how monetary policy should, and can, be conducted in a common currency framework?
I want to warn readers at the outset that I am not a financial macroeconomist. Because this is not my field of specialisation, my knowledge of how monetary policy is conducted and how it affects the real economy that is, of the so-called transmission mechanism — is only superficial. I can only hope that this does not invalidate all that I would like to offer in my attempt to fulfil the role assigned to me as a microeconomically oriented scholar in banking and business finance.
Reinhard H. Schmidt

7. European Labour Markets and the Euro: How Much Flexibility Do We Really Need?

In addition to evidence on the nature and source of regional fluctuations, European Monetary Union (EMU) will also provide economists with valuable new evidence on the monetary transmission mechanism. Given the scepticism with which macroeconomics currently regards monetary policy, current concern over real effects of EMU comes as a surprise; in a world of flexible prices, space-spanning contingent claims markets and complete information, it is difficult to see why monetary union matters at all for real integration processes already underway.1 For example, if the real business cycle paradigm (RBC) — which emphasises disturbances and propagation mechanisms in the non-monetary economy and ignores nominal rigidities — is approximately correct, the EMU exercise is nothing but a sophisticated veil. To the extent that EMU leaves fiscal policies and real behavioural incentives unchanged, the effects of a common currency are of second order at best. In short, this chapter has no real reason to be written.
Michael C. Burda

8. The Monetary Transmission Process: Concluding Remarks

In order to be successful in conducting monetary policy, central banks need to have a good understanding of the working of the economy, including an accurate assessment of the timing and the effects of changes in the policy instrument on inflation and economic activity — that is, the monetary transmission process (MTP). Such an assessment is necessary in order to tailor the policy response to unexpected developments in the economy and successfully maintain price stability.
Otmar Issing


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