EMU Monetary Policy: Aggregates and Stability

Monetary Policy in the EMU

Both a two-level strategy and direct monitoring play important roles. Monetary aggregates serve as intermediate variables in the first approach and as qualified indicators in the second.

Monetary aggregates indicate the liquidity within the economic system. While cash (notes and coins) is the most obvious representation of liquidity, modern economies feature other financial instruments with a high degree of liquidity that act as money substitutes.

Monetary aggregates are defined as the sum of cash in circulation and balances of certain instruments with a high degree of liquidity.

Central banks set monetary aggregates as variables because their purpose is crucial to monetary policy. Numerous economic studies confirm that inflation, in the medium and long term, is a monetary phenomenon.

Monetary Aggregates Defined:

• Narrow Aggregate (M1): Includes cash (notes and coins) and balances immediately convertible into money or usable for non-cash payments, such as demand deposits.
• Intermediate Aggregate (M2): Includes M1 plus term deposits up to two years and deposits redeemable at notice up to three months.
• Broad Aggregate (M3): Includes M2 plus certain securities issued by emitting sectors. This aggregate encompasses money market assets, specifically holdings in money market funds (MMFs) and other money market instruments, as well as repurchase agreements. Due to their high liquidity and price certainty, these instruments are close substitutes for deposits.

Monetary Control Strategy

Quantitative Definition of Price Stability

In 1998, the European Central Bank (ECB) announced a quantitative definition: "Price stability is defined as an increase of the Harmonized Index of Consumer Prices (HICP) for the euro area below 2%." The aim is to keep inflation rates below 2%, but close to this value in the medium term.

The Two Pillars of Strategy:

The first pillar involved establishing a reference value for M3. The second pillar included the monitoring and regular analysis of a wide range of other economic and financial indicators that affect price evolution in the short to medium term.

The ECB defines its strategy as a hybrid approach, combining a strategy based on establishing intermediate monetary targets with direct monitoring, which could be termed a direct monitoring strategy.