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Asymmetric monetary policy in the Euro Area

Asymmetric monetary policy in the Euro Area. A new role for the ECB. Agenda . Introduction Definition of asymmetric monetary policy Why asymmetric Focus on the Euro Area Objective of the model Structure of the model The outcome The model Limitations Evidences.

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Asymmetric monetary policy in the Euro Area

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  1. Asymmetricmonetary policy in the Euro Area A newrolefor the ECB

  2. Agenda • Introduction • Definitionofasymmetricmonetary policy • Whyasymmetric • Focus on the Euro Area • Objectiveof the model • Structureof the model • The outcome • The model • Limitations • Evidences Alessandro Cordova - Asymmetric Monetary Policy

  3. Definition • Useofconventionalmonetarytoolsdifferentlyacrossfinancialinstitutionsof the MemberStatesof a MonetaryUnion Alessandro Cordova - Asymmetric Monetary Policy

  4. WhyAsymmetric? Theory: A monetaryunionissustainable over the long-term if business cycles converge over time. Implication: Either shocks must be symmetric in nature and have the same impact across Member States or the currency area must be endowed with a “flexible” economic structure allowing for shocks to spread similarly across countries (Optimal Currency Area-OCA) Alessandro Cordova - Asymmetric Monetary Policy

  5. Focus on the Euro Area The Euro Area isnotanoptimalcurrency area • Prices and wageflexibility • Labor and capital mobility Especially… 3. Constrainednational fiscal policies Alessandro Cordova - Asymmetric Monetary Policy

  6. Objectiveof the model • Show howidiosyincraticshocksleadtodiverginginflation and output gapsacrossMemberStates via the impact on the market forreserves • Analyze the resultsachievedbyuniform vs. asymmetricmonetary policy. Alessandro Cordova - Asymmetric Monetary Policy

  7. Structureof the model • Twocountries: Greece and Germany • Tworepresentativebanks • Idyosincraticshocksprovoke: • Loweramount/valueofcollateral • Higherinterbank interest rate • Impact on the reserve market • Mainrefinancingoperations • Overnight Interbank market • MarginalLendingFacility • MonetaryTools: • Collateralrequirementswhenborrowing at the ECB • Interest rate on the MarginalLendingFacility Alessandro Cordova - Asymmetric Monetary Policy

  8. Collateral shock- The outcome • MROs Greek (German) banksobtainfewer (more) reservesthanrequired 2. Interbank market Shortagefilled in the interbank market and MLF (costly) 3. Result Greekbanks are worse off and Germanbanksbetter off 4. UniformMonetary Policy Increasemoneysupply and lower minimum interest rate leadstohigherinflation in Germany 5. Asymmetricmonetary policy AcceptlessvaluablecollateralbyGreekbanksoffsets the initialfall in the valueofcollateral Alessandro Cordova - Asymmetric Monetary Policy

  9. Interbankrate shock-The outcome • MROs German(Greek) banksobtainfewer (more) reservesthanrequired 2. Interbank market Germanbanks are NOT worse off 3. Result Greekbanks are stillworse off 4. UniformMonetary Policy Lowerimlfforbothbanksleadsto a lowerinterbank rate forGermanbanks 5. Asymmetricmonetary policy Lowerimlfforgreekbanksonlylowestheirinterbank interest rate Alessandro Cordova - Asymmetric Monetary Policy

  10. The model • Formula: • Linear functioninsteadofstepfunction • Constantmarginalcostofcollateral (B) (Ewerhart, Cassola, Valla 2006) • Focus on twobanks: Greek and German • First, equalcollateral and interbank rate • Then, the shockmodifies the collateral and/or the interbank rate ofoneof the twobanks (idyosincraticshocks) Alessandro Cordova - Asymmetric Monetary Policy

  11. Inverse bidschedule Alessandro Cordova - Asymmetric Monetary Policy

  12. Inverse bidschedule-modification Alessandro Cordova - Asymmetric Monetary Policy

  13. Overnight interbank market Alessandro Cordova - Asymmetric Monetary Policy

  14. Supply and demandschedule-Modification Alessandro Cordova - Asymmetric Monetary Policy

  15. Collateral shock forGreekbanks Inverse bidschedules Collateralforgermanbanksconstant Bgreefalls Assume supplyofreservesremainsconstant The stop out rate falls EXTRA reservesforGermanbanks SHORTAGE ofreservesforGreekbanks Alessandro Cordova - Asymmetric Monetary Policy

  16. Collateral shock forGreekbanks Alessandro Cordova - Asymmetric Monetary Policy

  17. Collateral shock forGreekbanks Alessandro Cordova - Asymmetric Monetary Policy

  18. Collateral shock forGreekbanks Alessandro Cordova - Asymmetric Monetary Policy

  19. Collateral shock forGreekbanksUniformmonetary policy Alessandro Cordova - Asymmetric Monetary Policy

  20. Collateral shock forGreekbanksUniformmonetary policy • Extra reserves are likely to increase the amount of loans German banks can make, leading to a stronger economic activity in Germany, eventually putting upward pressure to prices. • Instead, if extra reserves are hoarded, thenGermanbanks position wouldworsen. • As the mandate of the ECB is primarily to guarantee overall price stability, the change in inflation rates for countries that have not suffered the shock (Germany) limits the scope of intervention. Alessandro Cordova - Asymmetric Monetary Policy

  21. Collateral shock forGreekbanksAsymmetricmonetarypolicy • If the ECB allowed different financial institutions to post different assets as collateral in the auction, then the shock suffered by Greek banks would be limited. • By allowing Greek banks to have a wider pool of assetsto use in the tender procedures, the MC of posting collateral will be diminished. This corresponds to an outward pivot of the inverse bid schedule for Greek banks, as opposed to the inward pivot caused by the initial shock. Alessandro Cordova - Asymmetric Monetary Policy

  22. Collateral shock forGreekbanksAsymmetricmonetarypolicy Alessandro Cordova - Asymmetric Monetary Policy

  23. ModelLimitations • Moralhazard DiscretionaryMonetary policy Acceptonlyassetswhosefall in price doesnotdepend on the riskundertakenby the banks • Greekbanks-makessense? Multinationalbanksbranchesalsoborrow in the MROs Benchmark (% oflending in Greeceas a portionof total loans)toavoidarbitrage • Longertermrefinancingoperations The modelisstillvalid: bothauction and interbank market • Static • Closeeconomy Alessandro Cordova - Asymmetric Monetary Policy

  24. Interbank interest rate shock • Inverse bidschedule Interbank rate forGermanbanksconstant forgreekbanksincreases Assume supplyofreservesremainsconstant The stop out rate rises EXTRA reservesforGreekbanks SHORTAGE ofreservesforGermanbanks Alessandro Cordova - Asymmetric Monetary Policy

  25. Interbank interest rate shock Alessandro Cordova - Asymmetric Monetary Policy

  26. Interbank interest rate shock Alessandro Cordova - Asymmetric Monetary Policy

  27. Interbank interest rate shockUniformmonetary policy Alessandro Cordova - Asymmetric Monetary Policy

  28. Interbank interest rate shockAsymmetricmonetary policy Alessandro Cordova - Asymmetric Monetary Policy

  29. Optimalcurrencyareas and the Euro Area Were business cycles synchronized? NO. In fact, Maastricht convergence criteria. Are they now ? “Revenge of the optimum currency area” – recent article by Paul Krugman “The EMU has not affected historical characteristics of member countries’ business cycles and their cross-correlations”-ECB Working Paper 1010 , (2009 ) Instead, “One significant feature of Euro Area inflation differentials is their persistence” - Jean-Claude Trichet (2006) What went missing? OCA criteria. Alessandro Cordova - Asymmetric Monetary Policy

  30. Empiricalexercise • Taylor ruleapproach Divergencebetween ECB targeted interest rate (the Eonia) and the optimal interest rate (the rate each NCB wouldhave target in absenceof a monetaryunion). Data IMF Annual Naturalreal interest rate calculated via the taylorrule Differentresponsecoefficientsattempted Alessandro Cordova - Asymmetric Monetary Policy

  31. Optimal interest rate vs Eonia If the Euro Area is an optimal MU, the two rates equal each other. Alessandro Cordova - Asymmetric Monetary Policy

  32. DivergenceTable Alessandro Cordova - Asymmetric Monetary Policy

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  37. Results • All these evidences aim at showing the limit of a non-optimal MU: no single country is able to achieve its optimal response to current economic conditions. • The cost may become very high when shocks are isolated and national fiscal policies are constrained by political inertia or high costs of borrowings. • This is where asymmetric monetary policy comes in. Alessandro Cordova - Asymmetric Monetary Policy

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