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Uncommon Markets
Subject Monetary Policy
Topic International Finance
Key Words Economic Growth, Unemployment, Interest Rates, Monetary Policy
News Story

The European Union (EU) is an association of 12 countries that have entered into an agreement to create a free-trade area with a common currency. One of the primary problems that an economic union must face is reaching consensus on a common monetary and fiscal policy. An 18-member board of governors, which includes the presidents of all 12 of the EU country's national banks, decides monetary policy measures. The current debate within the board is whether to lower interest rates. The smaller EU countries are experiencing economic growth and are afraid that lowered interest rates will be inflationary. The economies of the larger EU countries are relatively stagnant and would like to have interest rates lowered.

The public perception of the European Central Bank's (ECB) is that there is considerable confusion about the direction of monetary policy. There have been public pronouncements of a rate cut followed by denials, followed by a rate reduction of one-quarter percent. Analysts argue that the structure of the board of governors has limited its flexibility. Although Germany is the largest of the EU economies, it only has one vote on the ECB's board. If all of the member countries had similar views of the direction of monetary policy there would be no problem. However, the smaller EU countries favor rate stability or slight increases in rates, while the larger economies are pushing for rate cuts. The ECB has tried to govern by consensus building, that is, postponing a decision until a consensus of members agree on a monetary measure. Consensus building is becoming increasingly difficult.

The ECB has adopted a target inflation rate of 2 percent, as an average for the EU. If the faster growing countries have inflation rates of 2 percent, than Germany, one of the large slow-growing economies, for example, might be close to deflation and this would have a restrictive effect on economic growth.

(Updated August 1, 2001)

Questions
1. Using aggregate demand/aggregate supply diagrams illustrate an economy with an inflationary gap. Illustrate how an increase in the rate of interest will affect the gap.
2. Long-term unemployment appears to be a significant problem in Germany. Illustrate using an aggregate demand/aggregate supply diagram how a decrease in the rate of interest would affect the unemployment rate.
3. If the smaller EU countries have high growth and low unemployment while the reverse is true for the larger countries, what other policies could the EU propose that might help both large and small countries?
Source Edmund L. Andrews, "A Central Bank in All Directions," The New York Times, June 27, 2001.

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