: In this paper we intend to highlight the limits of ECB in managing the macroeconomic shocks in the Euro zone. We consider that in the last months the ECB monetary policy rate loses its effectiveness and, consequently, should be offset by other measuresinflation, Euro zone, European Central Bank, monetary policy, macroeconomic shock

Capraru Bogdan

Ihnatov Iulian Romeo

English

Research Papers in Economics

509 
 
LIMITS OF ECB MONETARY POLICIES ON ADJUSTING MACROECONOMIC 
SHOCKS 
 
Căpraru Sebastian Bogdan 
University”Al.I.Cuza” of Ia i Faculty of Economics and Business Administration Bd. Carol I, no. 
22 Email: csb@uaic.ro Phone: +40-232-201610 
Ihnatov Iulian Romeo 
University”Al.I.Cuza” of Ia i Faculty of Economics and Business Administration Bd. Carol I, no. 
22 Email: iulian.ihnatov@uaic.ro Phone: +40-232-201569 
 
Abstract: In this paper we intend to highlight the limits of ECB in managing the macroeconomic shocks in 
the Euro zone. We consider that in the last months the ECB monetary policy rate loses its effectiveness 
and, consequently, should be offset by other measures of economic and social policy. For demonstrating 
this conclusion we have analyzed inflation rate, GDP growth rate and output gap per country and per 
Euro zone as a whole. 
 
Key words: inflation, Euro zone, European Central Bank, monetary policy, macroeconomic shock 
 
The article’s JEL code: E52, E58 
 
Introduction 
In this paper we intend to highlight the limits of ECB in managing the macroeconomic shocks in 
the Euro zone. For this purpose we analyzed the main macroeconomic indicators that can be 
influenced by the monetary policy of ECB.  
To highlight the differences between the Economic and Monetary Union countries we analyze 
two macroeconomic indicators (inflation rate and GDP growth rate) per country and per Euro 
zone as a whole. Also, the analysis highlights the position of economic cycle in the Euro zone 
based on the output gap calculated by OECD. 
 
Theoretical approaches 
Theory of optimal currency areas examines the opportunity of renouncing at the exchange rate as 
a monetary policy instrument and of adherence to a monetary union. In his 1961famous article, 
R. Mundell analyzes various adjustment mechanisms in a country (region) that is exposed to an 
asymmetric shock. Later, R. McKinnon, P. Kenen and other authors have focused on analysis of 
costs  and  benefits  of  joining  the  monetary  union,  including  the  survey  of  new  policies  and 
mechanisms for adjustment. 
The Euro zone is likely to face asymmetric shocks, while the European Central Bank should 
respond through appropriate monetary policy. It is responsible for maintaining price stability and 
for the macroeconomic stabilization in the Euro zone as a whole. 
In  the  case  of  a  "pure"  asymmetric  demand  shock  (positive  developments  in  a  country  are 
accompanied by negative developments of equal size in another country), aggregate inflation and 
unemployment at monetary union level remain unchanged. In this extreme situation the ECB 
cannot use any instrument to stabilize the economies of affected countries. The ECB's inaction 
will  generate  a  higher  inflation  in  the  booming  economy  and  higher  unemployment  in  the 
economy in recession, compared with a situation in which the two countries enjoyed independent 
national monetary policy. 
In the other extreme case, when a „pure” symmetric shock occurs, the demand in both economies 
evolves in the same direction. In this case, the ECB may use the instruments of stabilization as 
the unemployment (or inflation) is increasing in the Euro zone. Thus, from the perspective of the 
same country facing the same type of shock, ECB may adopt different policies, as these depend 
also on the other EMU countries economic situation. 510 
 
A conclusion after analyzing these extreme cases is that the efficiency of the ECB's monetary 
stabilization instruments depends on the degree of shocks’ symmetry or asymmetry. It should be 
noted that these extreme cases does not exist in reality, but there is a combination of symmetric 
and  asymmetric  socks  in  EMU.  Consequently,  the  symmetric  component  of a  shock  can  be 
stabilized by monetary instruments and the asymmetric one will be managed by other types of 
policies. Figure 1 decomposes a mixed real shock in the two components and illustrates the 
movement  of  Phillips-curve  along  the  stability  line.  The  unemployment  rate  will  fluctuate 
between the corresponding points B and B', which is unacceptable from the perspective of an 
individual country. There could be better results in the case of independent national monetary 
policies (points A and A'). 
 
Source: De Grauwe ,P.,  Economics of Monetary Union, 6th Edition, Oxford University Press, 2005, 
p.196 
Figure 1: ECB Stabilization monetary policy 
 
Therefore, the monetary union has a problem of insufficient stabilization, with no solution in the 
case of temporary asymmetric shocks. If the countries of the monetary union don’t form an 
optimum currency area, the ECB will have a difficult mission and whether the optimum currency 
area criteria are met, the stabilization of employment and supply will be relatively easy. 
 
Data analysis 
We start the analysis of the asymmetric shocks extent in the Euro zone
297 by observing the GDP 
growth rates and inflation rates in the monetary union member countries. 
 
                                                       
297 Slovenia adopted euro on 01.01.2008 and Slovakia on 01.01.2009. We won’t include the latter in the analysis. 
Unemployment 
I
n
f
l
a
t
i
o
n
 
H 
UN 
E 
S  A’ 
A 
B 
B’ 
Stabilization:  
symmetric shock 
Lack of stabilization:  
Asymmetric shock 511 
 
 
Source: Eurostat (http://ec.europa.eu/eurostat) 
Figure 2: Real GDP growth rate (%) in 2007 and 2008 
 
We note a very different evolution of the GDP growth rates in the Euro zone (Figure 2). Thus, 
growth rates were between 2 to 7% in 2007, while the Euro zone average was approximately 
2.5%. For example, Ireland, Italy and Luxembourg faced a GDP decreasing, while in Cyprus and 
Slovenia GDP increased by more than 3%. In 2008, the growth rates reflected the international 
financial crisis. We note that countries such as Ireland, Italy and Malta had a GDP decrease, 
while the Euro zone as a whole had a GDP growth rate of less than 1%. 
Thus,  different (and  sometimes  negative)  growth rates require the use  of  different economic 
policies. The ECB is unable to use monetary tools to support individual policies, since its policy 
is drawn for the whole Euro zone and not by the requirements of individual EMU countries. 512 
 
 
Source: Eurostat (http://ec.europa.eu/eurostat) 
Figure 3: Inflation rate (%) in Euro zone in 2007 and 2008 
 
Figure  3  reveals  various  developments  in  the  Euro  zone  countries  in  terms  of  inflation  rate 
(calculated on the base of harmonized index of consumer goods prices). In 2007, inflation in 
France, Netherlands and Malta was below the Euro zone average (about 2%), while Slovenia and 
Ireland have experienced inflation rates above average (between 3 and 4%). In 2008, the sharp 
rise of the energy prices and the international financial crisis generated global price increases. 
However, we  note the impossibility of ECB monetary policy to adapt to  the realities of the 
individual EMU member countries. 
Differences between growth rates and inflation rates in the Euro zone countries may partly be due 
to permanent asymmetric shocks. In this case, under optimal currency area theory, the solution is 
changing long-term relative prices
298. The ECB monetary policy has minimal possibilities of 
influencing the asymmetric component of these shocks, but it can only soften the difficulties of 
adjustment for achieving long term equilibrium. 
The  asymmetric  component  of  shocks  and  the  stabilization  problem  may  be  emphasized  by 
analyzing the Figure 4. It shows the output gap, i.e. the spread between the real GDP and the 
potential long run GDP of a country. This indicator, calculated by OECD, measures the business 
cycle position of a country. 
 
                                                       
298 De Grauwe, P., Economics of Monetary Union, 6th Edition, Oxford Univ. Press, 2005, p.36 513 
 
   
Source: OECD Economic Outlook 84 Database 
Figure  4: Output gap in 2007 (left) and 2008 (right) 
 
We can observe that a number of countries such as Portugal, Spain and Italy confronted with a 
slow-down  of  their  economies  in  2007,  while  others,  like  Greece,  Finland  and  Ireland  had 
booming  economies.  The Euro  zone  as  a  whole
299  recorded  a  growth  rate  over  its long  run 
potential (expansion phase of the economic cycle). In 2008, the Euro zone economy had a GDP 
growth rate below its long run potential. In the latter year, the Euro zone economies slowed down 
due to global financial and economic crisis. 
Hence, the growth and inflation rates of the Euro zone countries had important relative variations 
from country to country. Considering the inflation rates and the output gaps, it results a different 
optimum monetary policy interest rate for each country. For instance, a country like Ireland or 
Italy with a slowed down economy would require a monetary policy interest rate that stimulates 
the recovery. On the other hand, a higher monetary policy rate would be useful for Slovenia, a 
country with a booming economy and a higher inflation rate. 
 
Conclusions 
The above analysis reveals that the inflation rate and the GDP growth rate had very different 
values for each Euro zone country compared to other countries and to the Euro zone as a whole. 
Additionally,  the  analysis  shows  that  the  position  of  the  economic  cycle  of  the  Euro  zone 
countries was different. These disparities magnified in 2008 as a result of increasing energy 
prices  and  of  international  financial  crisis.  Also,  Balassa-Samuelson  effect  could  have 
contributed to widening disparities in terms of inflation rates. 
The reaction of the European Central Bank in 2007 and 2008 was a sharp decreasing of the 
monetary policy interest rates from a maximum of 4.25% in July 2008 to 1.25% in April 2009. 
Given the evolution of inflation and GDP rates, if we were to apply the Taylor rule
300 for each 
EMU country, it would mean that the dispersion by countries of optimal monetary policy rates 
would increase. This observation could lead us to the conclusion that the ECB monetary policy 
rate loses its effectiveness and, consequently, should be offset by other measures of economic 
and social policy. 
                                                       
299 Excluding Cyprus, Malta and Slovenia, for which OECD hasn’t published the output gaps and, respectively, 
Slovakia that adopted the euro at 01.01.2009. 
300 Baldwin, R., Wyplosz, C., The Economics of European Integration, 2nd  Edition, McGrawHill, 2006, p.393 
-1,0  
-0,5  
0,0  
0,5  
1,0  
1,5  
2,0  
2,5  
3,0  
-4,0  
-3,0  
-2,0  
-1,0  
0,0  
1,0  
2,0  514 
 
 
Bibliography 
1. Baldwin, R., Wyplosz, C., The Economics of European Integration, 2nd  Edition, McGrawHill, 
2006 
2. Cerna, S., Teoria zonelor monetare optimale, Ed. Universită ii de Vest, 2006 
3. De Grauwe, P., Economics of Monetary Union, 6th Edition, Oxford Univ. Press, 2005 
4. El-Agraa, A.M., European Union. Economics and Policies, 7th Edition, Prentice Hall, 2004 
5. Mundell, R., A Theory of Optimal Currency Areas, in „American Economic Review” no. 
51/1961 
6. OECD Economic Outlook 84 Database, http://www.oecd.org/statsportal/  
7. Eurostat, http://ec.europa.eu/eurostat  
   

A Theory of Optimal Currency Areas,

Economics of Monetary Union, 6th Edition,

Teoria zonelor monetare optimale, Ed. Universită ii de Vest,

LIMITS OF ECB MONETARY POLICIES ON ADJUSTING MACROECONOMIC SHOCKS

http://steconomice.uoradea.ro/anale/volume/2009/v3-finances-banks-and-accountancy/85.pdf

LIMITS OF ECB MONETARY POLICIES ON ADJUSTING MACROECONOMIC SHOCKS

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