European Central Bank

European Central Bank Basics

Acronyms

Central task: price stability in the euro area

The most important task of the European Central Bank is the stability of the currency and thus also of the price level in the euro area. The Maastricht Treaty stipulated that the ECB should use the means at its disposal to maintain an inflation rate of just under 2% and thus avoid major fluctuations in the value of money. Experience has shown that a severe loss of monetary value (inflation) or a prolonged phase of falling prices (deflation) have a negative effect on the economy. According to ABBREVIATIONFINDER.ORG, European Central Bank is also known as ECB.

Since the introduction of the euro, the average inflation rate has been 1.7%, which is below the value for the previous three decades. For residents of the euro area, this means above all planning security for investments. Many experts see the 2% mark as an optimal value for the economy.

The decisions of the ECB with regard to price stability are closely monitored by the European control bodies and a critical public, as they affect around 340 million people who receive their wages in euros and who pay for their consumer goods in euros. The number of its residents makes the euro area the second largest economy in the world after the USA.

Other tasks of the bank are the safekeeping and administration of currency reserves, the issuing of euro banknotes and, last but not least, the smooth functioning of payment systems such as EC or bank transfers.

The financial instruments of the ECB

In order to fulfill its purpose, the European Central Bank has various monetary policy instruments at its disposal. The most important of them is the setting of the key interest rate in the euro area. In this way, the Governing Council determines the costs for which a commercial bank can borrow money from the ECB. Since the amount of money put into circulation can be given directly to the commercial banks in the respective euro countries via a so-called “permanent facility”, the ECB thus directly influences the level of the interest rate that is passed on from the commercial banks to the consumers. This then specifically plays a role when taking out a loan or saving money in a savings account, a building society loan agreement or in a life insurance policy.

Open market transactions are a very often used option that is directly linked to the ECB key interest rate in cooperation with commercial banks. Banks can borrow money from the ECB for a longer period at the interest rate also known as the “main refinancing rate” and obtain liquidity, i.e. fresh money. In return, the central bank buys securities (“bonds”) from the respective bank as collateral.

As part of the minimum reserve policy, European commercial banks must park a certain percentage of each deposit as a minimum reserve with the ECB. This is to prevent a bank from running out of capital in the event of the default of one or more debtors and unable to repay its loans. This is to avoid a chain reaction.

A rather marginal instrument used are foreign exchange market interventions. The ECB could use them to try to increase or decrease their value against the euro by buying or selling foreign currencies. In the bank’s view, however, it should only be used to compensate for gross mispricing of the euro exchange rate, which could jeopardize the inflation target. Such mispricing would occur if non-European countries, for example, deliberately devalue their currency in order to gain advantages for their export economy through the then low comparative value to the euro: Goods that have to be paid for in euros would then be significantly more expensive and could find fewer buyers.

New tasks for the ECB were added to these financial instruments in the context of the euro sovereign debt crisis, which from 2008 onwards increasingly led to major financial, economic and social problems in some southern European countries.

All decisions regarding monetary policy are taken in the Governing Council, the bank’s highest body. The members are composed of the presidents of the respective national central banks and the six-member board of directors. There, the decisions of the Council are implemented in concrete financial policy and the necessary instructions are passed on to the national central banks of the euro area. The national central banks form the European system of central banks with the European Central Bank. It is the task of the central banks to implement the financial policy of the ECB in the respective countries. The top director of the ECB is currently the Italian Mario Draghi, and a successor will be elected in November 2019.

European Central Bank