This Activity is designed to be used in the classroom or as a homework task to support the teaching and learning of Macroeconomic Problems.

The ECB, the Eurozone and Monetary Policy

This lesson will look at the theory underpinning monetary policy. It will review the main characteristics of the business cycle and how monetary policy can be used to deal with economic problems characterised by different phases of the business cycle.

Frankfurt, Germany, the home of the European Central Bank. Source: Adrian Kluthe, stock.xchng

We will then look at the decision by the European Central Bank (ECB) to raise interest rates and set this against the background of the economic performance of the eurozone.

You will be expected to recognise the complexities of decision making when operating macroeconomic policy and to understand the importance of using the 'it depends' rule when tackling questions that require an evaluative element.

The Problem:

After two years of stable interest rates, the European Central Bank (ECB) finally changed rates in December 2005 with a quarter point rise from 2.0% to 2.25%. The rate rise comes at a difficult time for the Bank - not much has really changed in the dilemma they have faced for a number of months, but their decision may just have been tipped by the impact of rising oil prices in the past nine months.

How do financial markets react when monetary authorities change bank rates? © Photolibrary Group

The ECB have been trying to keep inflation under 2% in the eurozone but in many countries, the pressure on prices has been rising, though not by very much. Expected inflation is 2.1% against a target rate of 2.0%. The main reason for this is the rise in oil prices, which is now starting to feed through to European economies.

As interest rates change, the effect is felt in currency markets as traders look to move currencies to financial centres that have better returns. In so doing, currency values appreciate and depreciate, affecting both importers and exporters. Title: Crane at port. Source: Keran McKenzie, stock.xchng

In many respects this has caused artificial problems, because the underlying trend in the economies of many in the eurozone is still one of low growth and rising unemployment. In August 2005, the International Monetary Fund (IMF) forecast a growth rate of 1.3% for the Eurozone - reduced from an estimated 1.6% - and they expect a lower growth rate than predicted in 2006 - 1.9% from 2.3%.

This is not a growth rate to set the pulse going and is certainly not a growth rate that might be associated with inflation running out of control. Germany, Austria and Italy have had growth rates of almost zero. In Germany, the unemployment rate is over 12%, which equates to over 5 million Germans out of work. Theory would not be suggesting that inflation would flourish in such an environment.

The rise in the interest rate also has to be seen against the background of interest rates elsewhere in the world, and here we can see something more closely related to what we would expect to see in theory. Interest rates in the UK stand at 4.5% and in the United States rates are 4% and expected to rise to over 5% this year. In such circumstances, we would expect funds to move to currencies that attract higher interest rates - which means the euro falling in value against the US dollar and sterling. Since early September 2005, the euro has fallen in value against the dollar, slipping from around £1 = $1.25 to £1 = $1.17 by early December 2005.

What this means is that exporters from the eurozone will benefit as prices will appear to be cheaper to buyers in the US as they get more euro per dollar. But for importers, prices will have appeared to rise - eurozone buyers will have to give up more euro to get the same amount of dollars or sterling. The effect here is that import prices will rise and this could lead to inflationary pressures. Raising the interest rate, therefore, would help to offset this trend in the euro against other currencies to some extent and hopefully reduce the inflationary impact.

Whether this proves a sound move is going to be subject to some debate and only serves to highlight the difficulties facing the ECB of trying to manage the economy of the eurozone that has 311 million people. There is concern being expressed at different levels of economic growth within the eurozone and also from the Organisation of Economic Co-operation and Development (OECD) that the rise in rates by the ECB will stifle any signs of economic recovery.

It all depends, of course, on how consumers in the eurozone react to the higher cost of borrowing and also how the currency markets react to the change as well as the expected movements in interest rates in the major economies in the next few months.

You can get further information on the ECB's decision as well as a series of questions relating to the decision by selecting this link, which will take you to our In the News podcast on this issue.