1. Introduction

The Eurosystem is described as Eurozone monetary authority for countries that collectively utilise the euro currency. Under Article 16 of the European Central Bank (ECB) Statutes, the ECB holds outright rights to approve the issue of euro bills. The main goal of ECB relates to price stability. Other objectives relate to financial integration and financial stability. ECB conducts various functions, including carrying out foreign exchange operations, implementing monetary policies in the Eurozone, and maintaining foreign reserves for member states[1]. Also, Eurosystem supports the conduct of policies trailed by capable authorities regarding the sensible regulation of credit bodies and financial system stability. To achieve its objectives, ECB has established various monetary policy instruments.

1.1. Problem Statement

The Eurosystem monetary policies aim at protecting the economy of Eurozone member states and also providing solutions to macroeconomic issues such as inflation, interest rates changes, and foreign exchange fluctuations. Thus, it is vital in ensuring price stability and financial stability. However, failure or inadequate instruments and policies can lead to devastating effects on member states. Therefore, it is required to develop measures to protect economies and establish reliable policies to achieve set objectives.

1.2. Research Questions and Objective

This paper will address various research questions such as; What are the objectives and instruments of the Eurosystem? What strategies does the Eurosystem apply to achieve its objectives? To what extent the two-pillar approach is based on the quantity theory of money? The objective of the study is to discuss the working and functions of the Eurosystem.

2. Overview of the Eurosystem

2.1. Monetary Policy Objectives and Instruments

Maintaining price stability has been the principal goal of the ECB, which implies preserving the Euro’s value. Price stability is vital for job creation and economic growth. Price stability is a critical provision of the EC Treaty monetary policy chapter. The EC Treaty has been tasked with maintaining price stability for various motives. Economic research proposes that monetary policy is critical in raising living standards and enhancing economic prospects by ensuring price stability in a long-term way. Also, the monetary policy theoretical foundations and past experiences show that price levels can be impacted by the monetary policy; therefore, ensuring price stability over the medium-term is the sole viable objective for a single monetary policy.

The Eurosystem operational framework comprises different instruments, which include credit institutions minimum reserve requirements, standing facilities, and open market operations[2]. Also, ECB has activated different non-standard monetary policies; for example, asset purchase programmes aimed at complementing the Eurosystem regular operations.

Open market operations: these are critical in indicating the monetary policy position, managing market liquidity situations, and steering interest rates. The Eurosystem comprises five kinds of financial instruments for open market operations (OMO). The reverse transaction is considered vital and may be carried out as a collateralised loan or repurchase agreement. There are various classes of OMO: Fine-tuning operations are designed to direct rates of interest and control liquidity situations and can be done through bilateral procedures or quick tenders on an ad hoc basis. Main refinancing operations carried out by the ECB entail consistent liquidity-providing reverse transactions with seven days regularity and maturity and are essential in providing the bulk for the financial sector refinancing^[3]. Long-term refinancing operations have three months’ maturity period and are liquidity-providing reverse transactions. Structural operations are conducted through debt certificate issuance, outright transactions, and reverse transactions.

Minimum reserves: they aim at building a structural liquidity deficit and stabilising interest rates in the money market. Reserve requirements are determined according to the balance sheet elements. The Eurosystem allows institutions to utilise average provisions for the purpose of stabilising interest rates. Thus, the reserve requirement is based on average everyday reserve holdings for the institution over a one-month maintenance period.

Standing facilities: they indicate the general monetary policy position, avail and fascinate instant liquidity and ascertain immediate interest rates in the market. Standing facilities consist of deposit and marginal lending facilities. The deposit facility is utilised by counterparties in making instant NCBs payments, and its interest rates provide a lower limit for immediate interest rates[4]. The marginal lending facility can be utilised by counterparties in acquiring NCBs instant liquidity alongside suitable assets, and its rate of interest offers an upper-limit for instant market interest rates.

2.2. Monetary Policy Strategies

The ECB monetary strategy offers an inclusive outline in which decisions regarding the suitable immediate future interest rates level are made. It is established on various universal philosophies that purpose at ensuring effective monetary policy conduct. ECB’s monetary policy consists of; a Two-Pillar methodology to the assessment of price stability threats and price stability quantitative definition. The strategy external communication reflects the monetary policy diversified approach adopted by ECB for internal decision making[5]. Price stability quantitative definition is the ECB’s strategy first element. Price stability definition as described ECB Governing Council entails a year-on-year increase in the Harmonised Index of the Consumer Prices (HICP) for the euro area of below 2%[6].” For ECB to expedite its price stability function, it requires to assess economic developments systematically. The approach of ECB in organising, analysing and reviewing the information pertinent for evaluating price stability risks is founded on distinct methodical viewpoints known as “two pillars;” monetary and economic analysis. Both establish the grounds for the Governing Council’s general evaluation of decisions regarding monetary policy as well as price stability risks.

3. The two-pillar approach

3.1. The quantity theory of money

The two-pillar monetary analysis depends on the close association between monetary growth and price increases. To indicate its obligation to monetary evaluation and offer a yardstick for the evaluation of monetary growths, ECB publicised the monetary aggregate M3 reference value. The reference value signifies the “natural” yardstick for evaluating monetary developments information content in euro areas[7]. The monetary analysis of ECB regularly evaluates monetary aggregate M3 growth and other financial or monetary variables. For instance, M3 components developments like time deposits and cash in circulation are researched since they provide insights into general fluctuations in M3. Monetary aggregate, as defined by the Eurosystem, comprises M1 (narrow), M2 (intermediate), and M3 (broad monetary aggregate). Such aggregates vary depending on the degree of convertibility, liquidity, transferability, marketability, and price certainty of assets they comprise. M1 consists of overnight deposits, coins, and banknotes. M2 consists of M1, and also deposits with specified maturity. M3 consists of M2 and specific marketable instruments like money market fund shares and repurchase agreements. The economic analysis emphasises financial situations and actual activity in the economy. The economic analysis assumes that price developments in short and medium terms are significantly impacted by demand and supply relationship, a similar concept exists in quantity theory of money.

3.2. Assumptions of the quantity theory of money

Quantity theorists based their propositions on various assumptions. Other factors remaining constant; the theory adopts the velocity of money (V) remains unchanged. Also, V is not influenced by shifts in the price level (P) or quantity of money (M). The V relies on interest rates, individuals’ habits, trade activities, and population. The theory also assumes that the quantity of goods and services (T) is constant and relies on transportation, labour productivity, production techniques, climatic conditions, and natural resources. This assumption also assumes the existence of full employment[8]. Quantity theorists assumed price as a passive factor and are influenced by other elements in the equation but not affect such elements. Quantity theorists also assumed an extended period, and V and T remained constant over a long period. The theory conveys the message that price levels are directly proportional to the money supply.

Monetary policy ensures price stability in different ways. It plays a crucial role in consumption by lowering interest rates, which facilitates borrowing. Thus, households can spend and invest more. Monetary policy stabilises the economy, for example, during the 2008 global financial crisis[9]. It enhances the economic growth rate by manipulating the accessibility and cost of credit, sustaining equilibrium balance of payments, and controlling inflation. Monetary policy also stabilises exchange rates and price levels to achieve its price stability objective.

4. Conclusion and Outlook

Monetary policy plays a crucial role in ensuring price stability in the Eurozone. Price stability is essential for economic developments and benefits nations in different ways. Price stability enables individuals to quickly identify shifts in relative prices, which are not obscured by general price level fluctuations. Consumers and businesses can thus make informed decisions regarding consumption and investment. The Eurosystem applies standing facilities, minimum reserves, and open market operation instruments to facilitate in achieving its price stability objective. The Governing Council of ECB makes monetary policy decisions every six weeks by evaluating monetary and economic developments. The monetary policy instruments aids in implementing monetary policy decisions. The two-pillar approach is useful in evaluating valuable information in making monetary policy decisions. Monetary policy steers short-term interest rates, thus influencing economic developments to sustain price stability in Eurozone.

5. Bibliography

Altavilla, Carlo, Luca Brugnolini, Refet S. Gürkaynak, Roberto Motto, and Giuseppe Ragusa. “Measuring euro area monetary policy.” Journal of Monetary Economics 108 (2019): 162-179.

Coghlan, Richard T. The Theory of Money & Finance. Macmillan International Higher Education, 2015.

Conrad, Christian A. “Die Geldpolitik der Europäischen Zentralbank.” In Wirtschaftspolitik, pp. 349-380. Springer Gabler, Wiesbaden, 2017.

Micossi, Stefano. “The Monetary Policy of the European Central Bank (2002-2015).” CEPS Special Report 109 (2015).

Pfannmöller, Jürgen. “Die Geldpolitik der Europäischen Zentralbank und der Euro.” In Kreative Volkswirtschaftslehre, pp. 179-203. Springer Gabler, Wiesbaden, 2018.

Pfannmöller, Jürgen. “Geld und Geldwert.” In Kreative Volkswirtschaftslehre, pp. 157-177. Springer Gabler, Wiesbaden, 2018.

Rohde, Armin. “BEURTEILUNG DER WIRKSAMKEIT UND MÖGLICHE RISIKEN DER AKTUELLEN GELDPOLITIK DES EUROSYSTEMS.” Discussions on Estonian Economic Policy 23, no. 2 (2015).

Thiele, Alexander. Die Europäische Zentralbank: Von technokratischer Behörde zu politischem Akteur? Mohr Siebeck, 2019.

[1] Conrad, Christian A. “Die Geldpolitik der Europäischen Zentralbank.” In Wirtschaftspolitik, pp. 349-380. Springer Gabler, Wiesbaden, 2017.

[2] Conrad, Christian A. “Die Geldpolitik der Europäischen Zentralbank.” In Wirtschaftspolitik, pp. 349-380. Springer Gabler, Wiesbaden, 2017.

[3] Pfannmöller, Jürgen. “Die Geldpolitik der Europäischen Zentralbank und der Euro.” In Kreative Volkswirtschaftslehre, pp. 179-203. Springer Gabler, Wiesbaden, 2018.

[4] Altavilla, Carlo, Luca Brugnolini, Refet S. Gürkaynak, Roberto Motto, and Giuseppe Ragusa. “Measuring euro area monetary policy.” Journal of Monetary Economics 108 (2019): 162-179.

[5] Rohde, Armin. “BEURTEILUNG DER WIRKSAMKEIT UND MÖGLICHE RISIKEN DER AKTUELLEN GELDPOLITIK DES EUROSYSTEMS.” Discussions on Estonian Economic Policy 23, no. 2 (2015).

[6] Micossi, Stefano. “The Monetary Policy of the European Central Bank (2002-2015).” CEPS Special Report 109 (2015).

[7] Thiele, Alexander. Die Europäische Zentralbank: Von technokratischer Behörde zu politischem Akteur? Mohr Siebeck, 2019.

[8] Coghlan, Richard T. The Theory of Money & Finance. Macmillan International Higher Education, 2015.

[9] Pfannmöller, Jürgen. “Geld und Geldwert.” In Kreative Volkswirtschaftslehre, pp. 157-177. Springer Gabler, Wiesbaden, 2018.