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Role of Central Banks and Monetary Policy


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Role of Central Banks and Monetary Policy


A central bank refers to a monopoly and a nationalised institution which has the responsibility of producing and distribution credit and money. Currently, the central banks formulate monetary policy. The central banks are anticompetitive and are neither government agency for purposes of ensuring that the institution remains politically independent (Sims, 2016, p. 3). Among the first prototypes of the modern central bank is the Bank of England which was established in the 17th century. The bank of England was also the first bank to exercise the duty of lender of last resort for other commercial banks. Other central banks that were popular were the Reich bank of German and Napoleon’s Bank of France. The two institutions were set up to finance military operations of the government which were expensive. The European central bank managed to facilitate the smooth running of the economy evident through the ability of the government to pay wages. Such significant contribution of the central banks challenged other nations to establish similar institutions to play different roles within the society (Sims, 2016, p.7).

Currently, most of the nations have established their local central banks with regional unions like the European Union creating the European Central Bank. Other central banks include the Bank of France, Bank of England and the Deutsche Bundesbank. The banks have the responsibility of formulating favourable economic policies which will promote sustainable growth in the local economy and also ensure that the nation remains competitive in the global market. Therefore, the central bank fiscal policies reflect an element of systems like the European monetary system. Besides, the economic crises that have happened in the past because of applying specific monetary policies guide the central banks in making better decisions that prevent an economic turmoil (Fratzscher, Duca, & Straub, 2014, p.102).

The role of central banks and monetary policies

The central bank has the responsibility of ensuring price stability through maintaining inflation at sustainable rates. The bank employs the fiscal policies to control the inflation rate. Some of the strategies which the bank uses to control money supply are performing open market transactions which inject more money into the economy (Fratzscher, Duca, & Straub, 2014, p.93). For instance, to promote economic growth in a nation experiencing slow growth rate the central bank buys back the financial instruments from the bearers. It is through paying the public for surrendering the financial instrument that the bank increases the quantity of money supply because the public has more to spend. Besides, the bank can initiate the bank can provide funds to lure individuals to invest in the public sector. On the other hand, when the government wants to reduce inflation, then it reduces the amount of money supply in the economy. The government, therefore, sells the government financial securities to the public.

Also, the central banks promote economic growth by ensuring that there is an adequate supply of financial resources in the economy. Therefore, the central bank engages in monetary expansion policies to supply more money to the markets. The central bank also regulates the services offered by other financial institution. The regulation is to ensure that the firms never use the client money in risky investments which are profitable for the financial institutions alone. Further, central banks are the lenders of last resort for financial institutions. Commercial banks borrow because they offer their clients’ funds on a first-come, first-serve basis. There when they lack adequate cash to meet their client needs, they acquire from the central bank. The financial institutions qualify to borrow from the central banks by maintaining the required reserve ratio. The reserve ratio is also a means by which the central banks regulate the amount of money supply in the economy. For instance, when there is an oversupply of money in the economy banks maintain a higher reserve ratio compared to when there is a minimum supply of money in the society. High quantity of reserves means that bank has less cash which they can lend as loans to the public while a reduction in the reserve requirement means that financial institutions have more money to offer as loans to the public.

Also, the central bank uses the discount rate which is the interest that banks pay for the financial assistance they get from the independent entity. Therefore, when inflation is high, the banks raise their discount rate, which discourages the tendency of banks to borrow from central banks. It also affects the cost at which the financial institutions are willing to loan their client and offer mortgages. Therefore, the cost of borrowing is high, and the public is discouraged from borrowing thus with time the supply of money in the economy reduces (Fratzscher, Duca, & Straub, 2014, p.97). Discouraging the banks from constant borrowing ensures that central banks monetary policies can achieve their objectives.

The background and early history of the European Monetary System

The Monetary System was established in the year 1979 to replace Bretton Woods Agreement in 1972. The new system was necessary because of the economic and political pressure across Europe at the time.  The objective of the European Monetary was, therefore, to attain both internal and external monetary stability across Europe. The system would also, promote economic cooperation among member states. The membership to the European Monetary System has been voluntary. Nations like Denmark, France, Germany and Italy have been members voluntarily since the inception of the system. Initially, the United Kingdom joined the system and then withdrew after a two-month run on its currency reserves. However, the nation became a member of the European Monetary System in October 1990. The European monetary system had three essential components which were an artificial currency known as the European Currency Unit, and the exchange rates which were subject to small fluctuations. The final part of the system was the credit and loan reserves which would assist in stabilising member state currencies during the crisis.

The European Currency Unit which was created in 1979 to replace the European Unit of Account that was previously used to determine the exchange rate (Weiler, & Kocjan, 2005, p.2). The value of the European currency comprised of the weighted values of the member state currencies compared to that of foreign currencies. The new technique of determining the exchange rate was considered useful in performing long-term financial transactions when compared to the European Unit of Account. The method involved macroeconomics calculations of determining the size of the national economy underlying each State’s currency to allocate weights to the money. There was also the periodic adjustment on the weighted value of the money which was happening after every five years. The adjustment made the importance of strong currencies rise while the value of the weak currencies declined. However, after 1986 the changes in interest rates ensured that the currencies fluctuation remained within a narrow range.
Besides, the European community was using the technique to prepare the budgets and also, floated loans on the international market that were in the denomination of  European Currency Unit.
The second component of the European Monetary System aimed at achieving stabilisation of the rate of currency exchange in the Member nations (Weiler, & Kocjan, 2005, p.4). The exchange rates set in 1979 had minimal changes at irregular intervals. Also, there was a moderate degree of floating allowed between currencies which would only rise to about six percent during periods of financial crisis in nations. The limitation in fluctuation of exchange rate motivated the financial institutions, and private investors to engage in long-term transactions with an assurance that they would not experience unexpected exchange rate gain or loss at the end of the operation. Also, the member states had the motivation to fight inflation and avoid deficit spending. Finally, the policy spurred investment while preventing a recession. Therefore, the pegged exchange rate levels were highly satisfactory in practice for over a decade.

The credit mechanism allowed member states to offer short and medium term loans during financial constraints. The short-term financing lasted between 30-45 days while the long-term long lasted five years. There was also a reserve fund set at 25 billion which was made up of 20% gold and 20% of the dollars held by each State’s central bank (Weiler, & Kocjan, 2005, P.6). The member states who received the loan were to cut on deficit spending and adopt measures that would reduce inflation. Finally, in the 1990s, the European Monetary System had the problem of conflicting economic programs among its members. The problem was mainly from the reunified Germany, and also the United Kingdom who withdrew from the program. In 1994 there was the development of European Monetary Institute which would help start European Central Bank and a common currency. In 1998 European Central Bank was formed and was charged with the responsibilities of, setting uniform monetary policy for the Eurozone nations. Finally, in 1999, the European Union members adopted the euro, for foreign exchange and electronic payments.

The principle reasons for Exchange rate mechanisms problems in the early 1990s

Speculative pressure to reconcile the stated exchange rate and the real rate was a significant problem facing the exchange rate mechanism. Since 1987 the exchange rates were stable, and there was no realignment of currencies. However, currencies like the peseta, the sterling, and the escudo became part of the exchange rate mechanism. The likelihood of experiencing another economic turbulent made the Europeans Members Union consider an incremental extension of the European Monetary System necessary for economic prosperity. The consideration was at the expense of realignment which was crucial in ensuring that the exchange rates were accurate and reflected the macroeconomic activities of each nation. Therefore, the failure to evaluate the exchange rates covered a significant source of instability.

The speculation on the real exchange rate and the nominal exchange rate was attributable to different rates of inflation whereby that of German and Italy differed by 10% in 1988. Thus, making the peseta overvalued when compared to the German currency. Also, there was a complaint that the sterling pound was overvalued in 1990. The fiscal policies and competitive positions in member states also affected the exchange rate mechanism. Failure to reconcile the real and nominal exchange rate made people speculate on the exchange rate as a method of correcting the inaccuracy. Besides, the main reason why the European exchange rate regime had previously succeeded due to frequent realignments. The realignments made it possible for the European Monetary System to execute substantial cumulative changes in exchange rates which were required to counter changes in costs and prices gradually. Therefore, without the realignment, the exchange rate never reflected the real value of the member state currency, and thus there was speculation (De Grauwe, 2018, p.12)

Also, the desire of a single currency which could be used by all member states enhanced the rigidity of the system Nugent. After the unification of Germany officials from the Bundesbank demanded D- Mark revaluation relative to the other currencies. However, they met resistance from France, a nation that believed the realignment would jeopardise the goal of European Members Union. France also, felt that the revaluation would undermine its franc fort policy. Even the European Monetary System developed a system that contradicted it overall objective leading to the early 1990s crisis.

Initially, the European Currency Unit was necessary for the exchange rate mechanism and that the divergence indicator would help identify the currencies which needed adjustment. Therefore, under the original plan adjustment would affect both the surplus and deficit countries. The arrangement caused controversies when there was the reunification of German. The claim in West Germany was that inflation rate in the European Monetary System would introduce inflationary bias into the system. Therefore, there was an intervention that put much pressure on the weak currencies when compared to the countries experiencing minimal inflation. The response saw nations with strong-currency issue more of its money, while the weak state draws its foreign currency reserves and borrow funds ((De Grauwe, 2018, p, p.6).  The limited nature of foreign reserves saw states with high inflation impose restrictive fiscal policies like rising interest rates to discourage domestic inflation and importing.

On the other hand, strong currencies in the European Monetary Systems like the D-mark became the nominal anchor of the system. The strength of the German currency made other members of the European Monetary System to conduct monetary policies that would maintain a stable exchange-rate. The need for realignment was eliminated by the annual rates of inflation which were consistent with the standards in Germany. The tendency of nations to imitate the financial measures of Germany made the exchange rate mechanism unstable as they pursued their domestic priorities thus misleading the other countries. Therefore, when the Bundesbank increased interest rates from 1990 to control local inflation, other European nations had to choose whether to raise their interest rates to ensure price stability but experience slow growth besides, an increase in unemployment (De Grauwe, 2018, p.14). They also had to decide if to allow the difference between their interest rates and that of German to reduce a decision that would make investors prefer the German currency at the expense of the local money.

Explain the movement of the European single currency and evaluate the success of the introduction of the single currency

Since the introduction of  Euro in 1999 mover 28 nations have adopted the currency as their means of exchange (MURSA, 2014, p.60). Usually, the euro moves within a narrow range when compared to strong currencies like the dollar. However, in 2007, the euro was under crisis a factor which made the currency weak. The euro strength against other world currencies is attributable to the single market within Europe. The market allows free trade which encourages people to trade significant volumes of commodities and factors of production.

The euro has reduced the exchange rate risks thus promoting trading activities of foreign companies. Currently, a company operating at a profit margin of 5% can continue its operation because of the certainty that the euro can only fluctuate within a given range unless there is an extraordinary economic event. Therefore, both the importers and exporters are assured of minimal effects on the transaction cost when doing business. When traders are confident about the exchange rate, there is an increase in the flow of goods and services across the European Union member states which fosters economic integration. The euro has seen the trade volume increase across Europe to the extent that the regions Gross Domestic Products makes up 14.6% of the global Gross Domestic Product (Mursa, 2014, p.61).

The Euro has also led to the creation of flexible exchange rates which have resulted in a reduction in the transaction costs. Besides, the countries using the Euro have seen their local economies grow and improve. A decline in the transaction cost has motivated nations to embrace specialisation. Therefore, firms within the countries which use euro can export its product to another country get paid in the same currency and use the revenues to pay its workers at home. There is avoidance of the cost of currency exchange which is healthy for the businesses. Also, nations which use the euro as a currency have managed to stop the use of monetary nationalism as a technique of increasing the competitiveness of national economies. The single currency has made it impossible for individual countries to devalue their currency at given intervals. When different nations were using their currencies, there was a tendency of governments to devalue their currency devaluation to promote exportation. The monetary policy results in a short-term effect which are beneficial to the exporters at the expense of the importers and the local consumers. Therefore, through a single currency, all parties were entitled the domestic prices would remain favourable.

Moreover, the Euro assisted nations which lacked fiscal discipline revise their economic policies. Such countries would consider increasing the international competitiveness by engaging in structural reforms instead of not manipulating the exchange rate of their currency. Besides, a single currency meant that governments could neither imprint fiat currency nor adopt populist policies (Mursa, 2014, p.62). The leaders from the democratic who know that citizens would oppose the idea of introducing taxes as a way of financing deficits, they would, therefore, facilitate inflation which would cause the prices of the commodity to increase. An increase in price would attract more revenue for the government which would pay the budget deficits. However, with the introduction of the Euro the leaders from democratic nations have been forced to adopt precautionary measures to reform the economy. The single currency acts as a sufficient standard because the leaders are unable to devalue the currency to solve their local economic challenges.


De Grauwe, P., 2018. Economics of monetary union. Oxford university press.

Fratzscher, M., Duca, M.L. and Straub, R., 2014. ECB unconventional monetary policy actions: Market impact, international spillovers and transmission channels. International Monetary Fund.

MURSA, G. (2014). Euro – advantages and disadvantages. [Online] Available at:–-advantages-and-disadvantages [Accessed 26 May 2018].

Nugent, N., 2017. The government and politics of the European Union. Palgrave.

Weiler, J. and Kocjan, M. (2005). The Law of European Union. [Online] Available at: [Accessed 26 May 2018].

Sims, C.A., 2016, August. Fiscal policy, monetary policy and central bank independence. In Kansas Citi Fed Jackson Hole Conference.










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