Central Banking, Monetary Policy, and Inflation in the Euro Area

European System of Central Banks (ESCB) and the Bank of Spain

ESCB Functions

• Define and implement the monetary policy of the euro area.
• Manage foreign exchange reserves and conduct foreign exchange transactions.
• Foster the proper functioning of payment systems.
• Authorize the issuance of legal tender banknotes.

Bank of Spain

The Bank of Spain is the national central bank of Spain and, within the framework of the ESCB, the monetary authority that regulates the activity of the country. National central banks have two types of functions: specific functions and functions as a member of the ESCB.

Specific Functions of the Bank of Spain

• Hold and manage foreign exchange reserves and precious metals not transferred to the ECB.
• Monitor the operations of credit institutions.
• Promote the smooth functioning of the financial system.
• Circulate coins.
• Prepare and publish reports and statistics.
• Act as the state's bank.
• Advise the government.

Functions of the Bank of Spain as a Member of the ESCB

• Define and implement monetary policy.
• Carry out foreign exchange operations.
• Promote the smooth operation of payment systems.
• Issue legal tender banknotes.

Monetary Base and Open Market Operations

The monetary base equals cash held by the public plus bank reserves. The European Central Bank uses the monetary base to control liquidity in the banking system. One way to control this base money is through open market operations. These operations involve the central bank of each country buying government bonds from commercial banks. In return for these bonds, commercial banks receive money in the accounts they maintain with the central bank, which increases their reserve requirements and therefore increases the monetary base. The fact that the central bank controls the monetary base affects the amount of money in the economy, or the money supply. The central bank has two ways to influence the money supply: altering the monetary base and changing the reserve ratio. This whole process is completed because the banks and the public collaborate.

The Money Market and Monetary Policy

The money market consists of the supply and demand for money. The demand for money is determined by the public's desire to hold money, and the money supply is determined by the central bank's monetary policy.

Monetary policy decisions are taken by the monetary authorities to modify the amount of money or the interest rate.

Explanatory Theories of Inflation

Monetarist Explanation

Monetarists believe that an increase in aggregate demand is due to an increase in the amount of money above the growth of production. If there is an increase in the amount of money, agents have more liquidity. Agents keep cash only for transactions; if the cash increases, it will be spent on profitable investments or the purchase of goods and services. However, assuming all inputs are employed, production cannot increase in the short term. Thus, the only way to meet this increased demand is through higher prices, and therefore it does not affect either production or employment.

Keynesian Explanation

Keynesians assume that economic agents demand money not only for transactions but also to hold it as an asset. As we know, one of the functions of money is as a store of value. It is possible that, in the very short term, an increase in the amount of money in an economy can be absorbed by the demand for money and thus not affect prices. Keynesians believe that, in the very short term, aggregate supply is horizontal, meaning we can increase production without affecting prices. This is possible because Keynesians believe there is involuntary unemployment due to insufficient demand.

The Effects of Inflation

The effects of inflation depend on whether it is expected and whether the economy has adjusted its institutions to cope with it.

If inflation is expected, the costs are:

• Shoe leather costs: Resources are wasted due to the need to frequently convert money into other assets.
• Menu costs: These are the costs associated with changing prices.