The Us Federal Reserve VS European Central Bank Essay Example for Free

The Us Federal Reserve VS European Central Bank Essay INTRODUCTION This paper will analyze the difference between U.S. Federal Reserve and the European Central Bank.   Provide assumption on which central banking system is able to provide stability on its respective country based on their approved mandates and what are the degrees of independence does Central Bank benefit from both in theory and reality and determine which central bank is able show better results in keeping the overall economy of its respective countries stable. COMPARISON BETWEEN THE US FEDERAL RESERVE AND EUROPEAN CENTRAL BANK The comparison of the Eurosytem and the Federal Reserve System is based on the following: institutional structure, the monetary policy strategy, the monetary policy instruments and the operating procedures of the two central banks as the focal point.    In the study conducted by Karlheinz Ruckriegel and Franz Seitz they concluded that the structure of both institutions has similarities but the main tasks and the legal status are by far different.   The main task of the Eurosytem is price stability while Federal Reserve objective is price stability and full employment achieving both all at the same time. Ruckriegel and Seitz believe in the importance of the independent status of the Eurosytem by international law (EU Treaty) gives an edge of the Federal Reserve System since the status of the Federal Reserve depends on Congress.   The Constitution gives Congress the power to set its value. Therefore, the Federal Reserve’s power is limited to views of the Congress.    They also noted the similarities in the operating procedures of monetary policy of both institutions, similarities in the design of the minimum reserves and the operating target. In both cases the overnight interest rate is the operating target of monetary policy. Apart from required reserves, the instruments of monetary policy are different. The differences can be traced back to historical factors, legal problems of the change of existing arrangements and a different understanding of monetary policy. In this context the Eurosytem has the advantage of introducing all arrangements according to the knowledge of monetary policy and theory. Therefore both writers classified the Eurosytem as the superior system under efficiency viewpoint. Especially, the obvious absence of strategy on the side of the Fed for several years. INFLATION AND UNEMPLOYMENT The difference between the US Federal Reserve and European Central Bank is that the first has a dual mandate which has an objective of prioritizing full employment and price stability at the same time whereas ECB is under the hierarchical mandates which the principal objective is stability other objectives is pursued once the inflation objective is met. The dual mandate of the Federal Reserve helps stabilize the inflation and unemployment situation of the country.   The dual mandate simply states to promote price stability and maximize employment meaning full-employment without pressure on inflation.   The key to dual mandate is to implement both objectives at the same time whereas European Central Bank has hierarchical mandates that prioritize price stability before pursuing other objectives.   ECB will only pursue other objective one’s price stability has been achieved.   Hierarchical mandates set inflation objectives in terms of forecast or as mid-term objectives this allows them to gradually return to their inflation objectives if there are changes in inflation. United States have the largest economy in the world their monetary policy has economic and financial effect on other countries.   The U.S. monetary policy involves influencing short-term interest rates and the supply of money and credit to promote basic goals established by the Congress.   According to Congress price stability normally implies that inflation should be low enough not to play a significant factor in economic decision making while â€Å"Maximum sustainable economic output and employment† goes well together with economic output and employment, it steadily grows consistent with the economy’s long-run ability to develop while strengthening price stability. In Euro the simultaneous decline in inflation and the labor share of income over the past two decades have motivated significant interest in how these phenomena might be connected.   In the summary of Katharine Neiss and Edward Neslon â€Å"Inflation dynamics, marginal cost and output gap:   Evidence from the three countries monetary policy analysis, suggests a different path from what is currently emphasized. They found little support that wage markup movements are an important source of inflation dynamics for a given output gap, and therefore concluded that more detailed modeling of labor market rigidities is not a high priority in analyzing inflation. On the other hand, they find that modeling the dynamic effects of real shocks not only productivity shocks but also preference shocks on potential GDP is crucial for understanding inflation behavior. They explicitly relate potential output dynamics to underlying shocks, hence the importance of optimizing models in monetary policy analysis. CENTRAL BANK’S DEGREE OF INDEPENDENCE For many years many countries has made progress in towards adopting legislative proposals removing their central banks from government control thus making them independent. Based on the empirical and theoretical studies it showed that there is no clear answer was shown that there can be an economic benefit to be gained in having an independent central bank.   In summary, empirical studies provide evidence of a negative correlation between central bank independents and inflation and central bank independence and fiscal deficits. Theoretical studies indicate that independent central bank can increase policy conflicts with the government whenever preferences of the two differ and in so doing worsen the economic performance of the country.   Both studies however do not provide support for the idea that countries should place monetary policy in the hands of the executive or legislative branches of government. Therefore empirical studies put emphasis on price stability and freedom to pursue these goals are primary determinants of independence whereas, theoretical studies equates independence with non-cooperation between the fiscal and monetary authorities in policy implementation. Each central bank representative on the panel brings with them instrument of independence this is used to isolate central bank from political interference.   This interference can be politically motivated.   The purpose of this insulation is not to allow the central bank to pursue policy preference.   The governments are consistent in defining broad goals for central banks, commitment from the government through central bank is to achieve different goals but their main objective is price stability. The Congress structured the Federal Reserve to be independent within the government therefore it is accountable to the Congress and its goals for economic performance are set by law. According to Governor Laurence H. Meyer on his speech At the National Association for Business Economics Seminar on Monetary Policy and the Markets, Washington, D.C. on May 21, 2001 in his speech he said: â€Å"Central bank independence is in part the result of formal institutional arrangements typically incorporated in the legislation defining and creating the central bank. The most important requirement is that the central bank is the final authority on monetary policy decisions. That is, monetary policy decisions should not be subject to the veto of the executive or legislative branches of government. This is further protected if other institutions of the governmenttypically the Treasury Department or the Ministry of Financeare not represented on the monetary policy committee. A lesser protection would be to allow such representation, but only in a non-voting capacity, as is the practice at the Bank of England and the Bank of Japan†. Instrument independence is facilitated by long overlapping membership terms, by limited opportunities for reappointment, and by protecting committee members from removal. Therefore the degree of independence that central bank enjoys is based on imposed mandates.   Though independent it is clear that it has its limitations there is generally an attempt to balance independence and accountability. CONCLUSION In conclusion it is believed that both European Central Bank and Federal Reserve has advantages.   It is predominant that it is the people, culture and society dictates which form is more advantageous.   Therefore applicability is based on culture and racial orientation. REFERENCES Bruha, Jan and Podpiera, Jiri, Inquirers on Dynamics of Transitions Economy Convergence in two Country Model working paper series No. 791August 2007 De Grawe, Paul Is the ECB Handicapped in Stabilizing Output Because of Rigidities? University of Leuven, 3/27/2007 Eurointelligence Some Notes on theReturn of Inflation ECB watch, 3/6/2007 Lawless, Martina and Whelan, Karl Understanding the Dynamics of Labor Shares and Inflation Working paper series No. 784, July 2007 Neiss, Katharine and Nelson, Edward Inflation Dynamics, Marginal Cost and Output Gap: Evidence from Three Countries February 2002 Pollard, Patricia, Central Bank Independence and Economic Performance Ruckriegel, Karlheinz and Seitz, Franz The Eurosystem and the Federal Reserve System Compared Facts and Challenges February 2002 Wyplosz, Charles Wake Up Call For The ECB, Institute of International Studies, 2/7/2007