South-Western College Publishing - Economics  
Where the U.S. Leads Should Others Follow?
Subject Monetary Policy
Topic International Finance
Key Words Inflation, Economic Growth, Money Supply, Currency Appreciation
News Story

The Federal Reserve, in an effort to stimulate aggregate demand, has cut U.S. interest rates twice in the last month. The U.S. action has caused many policymakers to look to Europe for similar policy measures. The president of the new European Central Bank rejected arguments that Europe needs to relax its monetary policy in order to spur economic growth.

Wim Duisenberg, president of the European Central Bank which oversees monetary policy for the 11 countries which will adopt the euro as their common currency this January 1, argued against interest rate cuts and capital controls as inappropriate for the current state of the economy. European policymakers have focused on establishing credibility for the euro and have not felt it necessary to stimulate economic growth. As a result, the mark and the franc have appreciated by almost 10 percent against the dollar since August.

Opinion in Europe over current monetary policy is far from unanimous. Chancellor-elect Gerhard Schröder is calling for a reduction in interest rates and the French Cabinet continues to complain about tight monetary policy.

There are signs that the world economic crisis is affecting Europe and that growth is slowing. The problems in Asia and Latin America are expected to decrease demand for European exports and the appreciation in Europe's currencies will make exports more expensive. European banks are reporting losses on loans and securities trading and are planning on eliminating thousands of jobs.

Setting monetary policy for the euro-countries is not as straightforward as it would be for a single country, since data quality and even how money is defined may differ. Some bankers have advocated basing monetary policy on money supply growth, while others have pushed for inflation targets. After considerable debate, Mr. Duisenberg announced that the European Central bank would use both money supply and inflation targets in setting monetary policy.

(Updated November 11, 1998)
Questions 1. How can the Federal Reserve bring about a reduction in interest rates?

2. Explain how a decrease in interest rates can increase aggregate demand.

3. European exports are predicted to decrease because of the continuing problems in Asia and Latin America. Explain how an expected decrease in European exports will affect European economic growth.

4. How will the increased strength of the mark and franc affect European exports? European economic growth?

Source Edmund L. Andrews, "No Need for World Rate Cut, European Bank Chief Says", The New York Times, October 14, 1998.

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