Forex Course

203. Bond Spreads Between Two Economies and Their Exchange Rate


Bond spreads play a vital role in the movement of currencies. The difference between the bond yield of two countries is called interest rate differential. It is more impactful on the currency direction as opposed to the actual bond spreads. The difference between the interest rate between the bond yield of two countries typically moves together with the corresponding currency pair.

Understanding The Impact

The prices of different currencies can influence the monetary policy decision by the central banks across the globe. However, monetary policy decisions, as well as interest rates, can also contribute to the price movement of the currencies. For example, a stronger currency will help control the inflation rate, whereas the weaker currency will contribute to inflation.

Additionally, the central banks harness this relationship as a means to manage the monetary policies in the respective countries. By comprehending as well as assessing these relationships and the patterns, people get a window into the currency market, thereby getting a means to forecast and capitalize on the currency movements.

An Example of This Relationship

In 2000, post the tech bubble burst, traders who were earlier looking for the highest returns shifted their focus on capital preservation. However, the U.S. was provided with below 2% interest rate, a lot of hedge funds, and those who had access to the international market moved abroad looking for higher yields.

Moreover, Australia has similar risk factors as the U.S. extended interest rate of 5%. Consequentially, this attracted a lot of investment money within the country, creating asset domination. This significant difference in interest rate resulted in the growth of the carry trade. In this, the investors bought currency from low yielding countries and invested in high yielding countries, and benefited from the difference in the interest rate.

Bond Spreads and Movement Of Currency

Bong spreads differential typically move together with currency pairs. This notion emerges as the capital flows move towards high yielding currencies. When there is an increase in one currency rate with respect to another currency, the investors move towards the higher-yielding currency.

Furthermore, the cost of acquiring lower-yielding currencies rises as the bond spread differential moves in favor of selling currency.

[wp_quiz id=”97499″]
Forex Course

153. The Affect Of Monetary Policy On the Forex Market


Fundamental analysis is one of the most reliable forex trading strategies in the world that considers economic releases and events. In fundamental analysis, many indicators provide a possibility of upcoming movement in a currency pair. Besides the economic release, some events like monetary policy decisions create an immediate impact on a currency pair.

What is Monetary Policy?

Monetary policy is an action or decision taken by the central bank to control the money supply and achieve the economic sustainability and macroeconomic goal. Every country has a strategic goal based on the current performance and upcoming economic growth of the economy. Therefore, most of the central bank changes the interest rate based on the economic condition.

Usually, the central bank sits quarterly for a monetary policy meeting to discuss the following four core areas:

  • Guideline for the money market
  • Interest rate decision.
  • Monetary policy measurement.
  • The outlook of the economic and financial developments.

How Monetary Policy Affects the Forex Market?

In a monetary policy meeting, the central bank discusses the present economic condition of a country. Therefore, any hawkish tone may create an immediate bullish impact on a particular currency. On the other hand, a dovish tone may create an immediate negative impact on a particular currency in any trading pair.

Besides the immediate effect, there is a long-term impact on the price of a currency pair. We know that any strength in an economy indicates a stronger currency. For example, if the ECB (European Central Bank) provides some consecutive outlook of the European economy saying that the inflation is under control, and the interest rate increased, which is likely to increase again in the next quarter. In that case, the influential European economy may create a Bullish impact on EURUSD, EURAUD, or EURJPY pair.

Moreover, there is some case where the central bank cut the interest rate where traders and analysts were expecting a rate hike. In this scenario, investors may shock at the news, and the effect might be stronger than before.

How to Trade Based on Monetary Policy Statement?

There is two way to trade based on the monetary policy decision. The first one is based on the immediate market effect, which is known as news trading. On the other hand, traders can evaluate the economic condition based on the recent monetary policy statement and see how the economy is growing in the long run. Based on this market scenario, traders can find a long term direction in the market based on economic performance as per the monetary policy statement.

Another way of trading based on the monetary policy decision is the fundamental divergence. If one fundamental indicator does not support another fundamental indicator, it creates fundamental divergence. For example, the US interest rate is increasing based on the strong employment report, but inflation does not support the rate hike. In this situation, traders can take trades with the possibility that the rate hike’s effect will not sustain.


Let’s summarize the effect of monetary policy in the forex market:

  • Monetary policy meeting happens quarterly where the central bank takes interest rate decision.
  • In the monetary policy meeting, the central bank provides an outlook of the economic and financial developments.
  • A hawkish tone makes the currency stronger, while the dovish tone makes the currency weaker.
  • Traders can identify the fundamental divergence based on the decision on monetary policy meeting.
[wp_quiz id=”86369″]
Forex Market Analysis

The Positive Data Reported in Canada could support a rate hike soon

Hot Topics:

  • The positive data reported in Canada could support a rate hike soon.
  •  The Greenback rally continues.
  • FTSE maintain the bull trend, DAX waits for ECB meeting?

Positive data reported in Canada could support a rate hike soon.

The consumer inflation (YoY) in March increased to the highest level in three years reaching 2.3%, climbing from the 2.2% reported in February. The Core Inflation (YoY) descended to 1.4% in March from the 1.5% in February. The higher oil prices have influenced inflation to rise. On the other hand, retail sales in February have increased to 0.4% from 0.1% reported in January. The Bank of Canada maintains a 2 percent inflation target; this scenario could signal an interest rate hike soon. In the last Monetary Policy meeting, the Bank of Canada decided to maintain the rate at 1.25%.

In the technical context, a correction for the Canadian Dollar group could show soon. In the EURCAD cross, we expect a bullish movement with a target placed in the 1.58 level before making new lows.

In the same way, GBPCAD is developing a bullish retracement process that could reach 1.805 – 1.81, the area from where it could make the bearish continuation of the main trend.

The Greenback rally continues.

For the fourth consecutive session, the US Dollar saw advances compared to its main competitors. The Euro has broken down its short-term consolidation structure but has been stopped by the lower trend-line of its long-term triangle pattern.

The Pound tested the 1.40 psychological level again, from where it is bouncing. We expect a retracement to a Fibonacci level before we decide to sell this pair.

The Swissy could visit the area between 0.9765 and 0.9836 before it makes a bearish cycle.

FTSE maintains the bull trend, DAX waits for ECB meeting?

The main European indices have closed with a mixed sentiment. The FTSE 100 closes the last trading session of the week climbing above the pivot level 7,326. We expect more upsides until the 7,450 – 7,520 area before it makes a bearish leg.

On the opposite side, DAX 30 could not climb up above the pivot level of 12,622. The German index could make a new bearish leg, likely to be around the 12,100 – 12,200 area before the ECB Monetary Policy Meeting and continue the bullish cycle.

© Forex.Academy

Forex Market Analysis

CAD slides in the aftermath of the BoC statement

In today’s meeting, Bank of Canada (BoC) left its interest rate unchanged, in line with expectations. It seems that overall approach of the BoC is wait-and-see, especially with respect to future hikes.

The statement notes that policy accommodation will still be needed in order to keep inflation on target while the Bank will continue to monitor economy’s sensitivity to higher interest rates.  In regards to projections, the Bank has cut Q1 GDP forecast to 1.3% from 2.5%, sees Q2 GDP at 2.5% while raising potential output growth to 1.8% in 2018-2020 period and 1.9% in 2021. In addition, the 2018 growth has been trimmed to 2.0% from 2.2% while for 2019 growth is boosted to 2.1% from the original 1.6%.

USD/CAD rose on the headline from 1.2550 to 1.2630 as the CAD hawks were not impressed with the content of the report. However, be caution since the price has already retreated 30 pips or so. As it can be seen in the chart below, the pair has moved way above  H1 100MA and touched 200 MA. In addition to the 200MA resistance on the hourly chart, the price has almost reached 38.2% Fibonacci retracement of the big leg down. If it is able to close above 1.26 tonight, we expect another leg higher to test at least 50% or even key 61.8% Fibonacci level. The diagonal trend line, currently at 1.2730, will also act as an obstacle for bulls.


All in all, our advice is to wait for the price to settle down before entering any trade.

Forex Educational Library

FOMC Statement- March 2018

The information received by the Federal Open Market Committee (FOMC), since its meeting in January, has shown signs of further strengthening of the labour market and economic activity has been growing at moderate but solid rates. Job gains have grown strong in recent months, and the unemployment rate has remained at low levels. Recent data shows that the growth rate of household spending and business fixed investment has grown in 2018 at moderate rates after a large growth at the end of 2017.

On a twelve-month basis, overall inflation and inflation for items other than food and energy has remained below 2%. The economic outlook has improved in recent months due to the good results evidenced throughout 2017, and since the tax reform approved at the end of the same year.

The committee expected that with gradual adjustments in the monetary policy stance, the economy would continue to behave positively in the medium term and labour market conditions would remain robust. Regarding inflation and its annual base, the committee expected that in the short term this indicator would be close to 2% and that the bank’s goal would be met.

Due to the behaviour of the labour market, the main sectors of the economy and inflation, the committee decided to raise the target range of federal funds from 1.5% to 1.75%. The committee was explicit in that the monetary policy stance would remain accommodative as long as it was necessary for inflation to return to 2%.

This decision was in line with market expectations, so there was no strong reaction from the market. In the projections of the path of the interest rate, there is still no unanimity on what the next steps of the Federal Reserve will be as some expect a stronger policy, so they expect four increases during 2018. For other analysts, the path will continue the road stipulated so they expect only three increases during the current year.

The following graph shows the main projections of the committee. This graph shows economic growth above the natural long-term rate and the rates expected since the December meeting has improved. The unemployment rate also shows a very positive behaviour and is below the long-term rate. Regarding the different inflation measures, inflation is expected below the bank’s target for 2018, but very close to the target level, and for the next two years, an optimal inflation rate is expected according to the bank’s mandate.

Graph 82.Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, March 2018. Retrieved 23rd March 2018 from

In the press conference, the president of the Federal Reserve Jerome Powell expressed that the decision to raise the target range of the interest rate marks another step in the normalisation of monetary policy, a process that has been underway for several years. But in his statements, some caution was evident and showing that the path of the interest rate considered only two more hikes in 2018.

Job gains averaged 240,000 per month in the last three months, which is a very positive rate and makes it possible for new workers to be absorbed. The unemployment rate remained at low rates in February, standing at 4.1%, while the rate of labour market participation increased.

According to Powell, that is a positive signal given that the economically active population is getting older, so this leads to the participation rate to the downside, but with the new entries this negative effect is offset by the entry of new workers.

Also, the president of the Federal Reserve has concluded that there are certain specific factors that have contributed to the greater economic growth observed in recent months and these are:

  • Tax reform
  • Ongoing Jobs Gains
  • Foreign growth is strong
  • Overall financial conditions remain accommodative

Regarding inflation, Powell was clear that inflation was still below 2% regardless of what measure was used. According to the president of the Federal Reserve, this was due to unusual price reductions that occurred in late 2016 and early 2017. But for Powell, as the months passed in 2018, these unusual events would disappear, and inflation would be very close to 2 %.

In his statements, the president of the Federal Reserve specified that, if the rates rose too slowly, this would increase the risk that monetary policy would have to adjust abruptly in the future if a shock should occur in the economy. At the same time, the committee wanted to prevent inflation from remaining below the target which could reduce the chances of acting quickly in the face of a recession in the US economy.

Finally, Powell pointed out that the reduction in the balance sheet that began in October was progressing smoothly. Only specific conditions of the economy could curb the normalisation of the balance sheet of the Federal Reserve. President Powell was emphatic that they would use the balance sheet in addition to the interest rate to intervene in the economy if a deep economic recession were to occur.

In conclusion, the federal committee decided to raise the federal funds rate as expected by the market due to the good performance of the economy which continued to grow at high rates and above the long-term level. Although inflation was not at the desired level, according to the committee, this was due to transitory effects that would fade over the months, and thus inflation would be in the target range.

As already mentioned, the economy showed good signs due to the labour market, so the bank decided to raise rates, but the committee remained cautious about the future of the economy because it was not ruled out that a recession would occur. According to the statements made at the press conference, some indecision was evident on the part of the committee as they evaluated the two possible scenarios against the interest rate.

If they raised it too quickly they could slow down the economy and thereby affect the labour market, which would lead to a drop in inflation, which would lead to a complex economic scenario as future increases would not be possible, and this would restrict the use of the monetary policy. On the contrary, If the committee raised it too slowly, a scenario could be generated where any economic shock, whether internal or external, could also affect the economic growth of the United States and limit future increases in the interest rate.

The market is still undecided if the FED will make two or three more rate hikes during the current year. Some analysts question why the Federal Reserve continues to raise rates if the inflation rate still shows no stability. For them, the central bank should be more cautious in its monetary policy because they could be in the second scenario where the economy still needs an accommodative policy so that the medium term could be limited future increases in the rate as well as the normalisation of the balance sheet.

Forex Educational Library

Monetary Policy Statements of Bank of Japan 2017


Category: Fundamental Analysis, Intermediate, Currencies, economic cycles, Monetary Policy, Economy, Macroeconomics, Central Banks.

Key Words: Central Banks, Monetary Policy, Bank of Japan.

Tags:  Macroeconomy, BoJ, Monetary policy, 2017.

At the January 2016 meeting, the Central Bank of Japan introduced negative interest rates, setting the reference rate at 0.1%. This negative rate meant that the central bank would charge commercial banks for some reserves deposited in Japan’s central financial institution. The measure was designed to encourage commercial banks to use their reserves to increase the supply of loans to consumers and investors in Japan, to reactivate the economy and overcome the deflation that the country was experiencing at that time.

This negative rate would not apply directly to the accounts that customers had with commercial banks so as not to affect the purchasing power of individuals or companies. It was not a measure taken impulsively since the Bank of Japan had been analysing what measures could boost the behaviour of inflation for several years.

The decision was made by the board of the bank in a split decision of 5 votes in favour of the measure, against four votes who did not agree to establish negative rates. In addition, the report issued summarising the meeting, stipulated that if it was necessary to delve into the negative rates territory, this measure would be only be implemented until the bank achieved its 2% goal.

This measure of establishing negative rates has not been common for the central banks of the world’s leading economies since there is no consensus on the possible effects of negative rates. A problem that had lasted for quite some time in Japan was the decline in the prices of goods and services so that consumers restricted their spending due to their expectations of prices in the future.

At the press conference, the governor of the Bank of Japan, Haruhiko Kuroda indicated that deflation coupled with a global economic slowdown led to an unprecedented policy for Japan. For many analysts, the decision to adopt negative rates was surprising, and it was not known how much this could influence the short and medium-term inflation rate.

The consensus for many analysts was that the Japanese economy did not grow at higher rates as well as inflation, not because of low supply of credits but because companies had pessimistic expectations about the future of the economy, so they preferred to postpone their investment decisions. Therefore, they hoped that the outlook would not change even with negative interest rates.

Specifically, the bank adopted a three-tier system in which the balance that commercial banks held in the central bank would be divided into three levels:

  • Balances with a positive interest rate
  • Balances with zero interest rate
  • Balances with a negative interest rate

This multi-level system in the balances was intended to prevent an excessive decrease in the income of financial institutions derived from the implementation of negative interest rates.

As for the guidelines for money market operations, the bank decided in a vote of 8 to 1 in favour of conducting operations in the open market until the monetary base was increased annually by 80 trillion yen. The bank decided to make purchases of Japanese Government Bonds (JGB) so that the amount in circulation would increase its annual rate of around 80 trillion yen.

By early 2017, the bank confirmed that the interest rate in the short term would remain at -0.1% and for the long term it would be 0%, so the bank decided to continue buying Japanese Government Bonds to maintain the yields of the bonds at 0%. World economic growth was moderate, but the negative performance was for the emerging economies which remained lagging behind the growth of the developed economies.

The bank especially highlighted the US economy, which showed great strength in almost all its variables, ranging from household spending to exports to the labour market. Inflation was perhaps the only variable that had not shown the strength of other economic variables but was close to the objective of the FED of 2%.

Japanese exports improved, mainly by the automotive sector. Private consumption was expected to have a positive performance in 2017 due to a good performance of the labour market, and effects on wealth, given the growth of the stock index in Japan and the main economies of the world. Real estate investment also showed positive signs since the end of 2016.

Given these positive signs, the bank expected a moderate expansion of the economy in 2017 given a rise in domestic demand for goods and services, in addition to better global growth and the depreciation of the yen, which would continue to boost exports.

The committee recognised that there was a lack of strength for the inflation rate to be at 2%, so it was important for the bank to continue with its guidelines and its operations in the market in order to continue channeling inflation towards the objective set by the bank’s mandates. The committee cleared doubts about its increase in long-term rates given the rate hike that the FED carried out, being very clear that its monetary policy decisions would only be based on local inflation conditions and not on decisions of other central banks.

At the mid-year meeting in 2017, the bank decided to keep the negative interest rate of -0.1% in a vote of 7 to 2. In order to maintain the long-term interest rate at 0%, the bank decided to buy JGB at the same rate as it had already done by increasing its holdings by 80 trillion yen.

By mid-2017 the Japanese economy had returned to a moderate expansion, with a slight increase in exports as well as fixed investment in businesses. Private consumption still did not show positive signs despite a better outlook in the labour market with wages rising slightly. In terms of the consumer price index, its annual measurement was close to 0%, so the bank was far from its annual growth goal, but expectations were positive because they expected an upward trend of this indicator.

The bank said it would continue with the Quantitative and Qualitative Monetary Easing (QQE) program until inflation rises above 2% in a stable manner that would allow for a path of economic growth that is larger than expected until mid-2017.

At in the October 2017 meeting, the bank committee decided with a vote of 8 to 1 to keep the short-term interest rate at -0.1%. For the long-term interest rate, the Bank of Japan continued acquiring JGBs to keep the interest rate at 0% for the long term. In the reports, it was indicated that the vote was not unanimous because a member of the board needed more encouragement from the bank to reach the goal of 2% as soon as possible.

In the meeting held in October 2017, the bank continued with its monetary policy of negative interest rate established at -0.1%. Yields on 10-year Japanese government bonds were still zero given the intervention of the central bank. The Nikkei 225 index rose considerably during 2017 given high expectations in the corporate results of Japanese companies.

As for the yen, it depreciated against the dollar during the year due to the interest rate differential between both central banks. Regarding its parity with the euro, it did not fluctuate significantly during the year.

As in the January report, the performance of the global economy remained positive, especially in the United States, which maintained a robust growth rate with good employment rates and good dynamics in its domestic markets.

In Japan, the economy grew at moderate rates with good dynamics in the export sector that was positively boosted by world growth. Fixed investment in businesses showed signs of moderate growth mainly due to an improvement in corporate revenues, better financial conditions and a better expectation of economic growth in the following quarters.

The unemployment rate has remained at low levels between 2.5% and 3%, which has encouraged greater private and household spending. The behaviour of real estate at the end of 2017 showed flat signs and the industry showed a growing trend. Regarding inflation, the Consumer Price Index (CPI) for the main goods minus food showed figures between 0.5% and 1%, as shown in the following graph.

Graph 76.CPI Inflation Japan 2017.Retrieved 26th February 2017, from

Although it is still not close to 2%, the behaviour of inflation has improved, and the bank’s expectations were that in the medium and long-term, inflation would be located at the bank’s target rate. It was clear to all board members that the engine of year-round growth was exports that benefited from a better global juncture.

If you compare the projections that the bank had in July and November, the projected inflation rate of prices decreased in November and was due to more pessimistic expectations about price growth and a reduction in mobile telephony, but the medium and long-term rates remained without modifications. For some members, there was still a long way to reach the goal of 2% due to an excess supply of capital and a labour market that still needed to be narrower, so that wage increases would be stronger.

In conclusion, given the behaviour of the economy during 2017, the committee determined that the economy needed monitoring continuously to achieve its goals in the coming years. The objective of inflation was met, but the board was satisfied with the macroeconomic development of Japan. For most of the members, it was clear that the monetary easing program should continue to support the different measures of inflation so that the expectations of businesses and households would change and spend more, boosting wages and prices.

There was also the concern that other banks were ending their monetary easing programs and in some cases, interest rates were rising, so this could put pressure on the yen’s exchange against other currencies. The monetary relaxation program had begun later in Japan, so the normalisation of its monetary policy could also take longer. Given these statements, it was easy to understand why the executive board still did not change the negative interest rates and its purchase of Japanese government bonds.


Forex Educational Library

Financial Report Bank of Japan 2017

The Bank Of Japan Financial System Report

The Bank of Japan publishes the Financial System Report twice a year in order to assess the stability of the Japanese financial system and facilitate communication with interested parties who are concerned about such stability. The bank provides a regular and comprehensive assessment of the financial system with emphasis on detailing the structure of the system and the policies taken to achieve a robust system.

The bank uses the results of the report to plan the policy to be followed, ensuring the stability of the financial system and provide guidelines and warnings to financial institutions. The bank uses the results of international regulation and supervisory discussions.

In the April 2017 report, the bank reported a notable rise in the prices of the main stock indices and interest rates after the election of the new president of the United States. In Japan, there was also a rise in the stock market and the Yen depreciated. The bank continued with its policy of Quantitative and Qualitative Monetary Easing with Yield Curve Control

The internal loans of the financial institutions in circulation had increased close to 3% annually. There were no signs of overheating in the activity of the financial system nor the real estate market. In general, the financial system had maintained good stability since the crisis of 2008. The capital ratios required by financial institutions were above the level requested by the central bank and had sufficient capital for the risk to which they were exposed.

The results of the macroeconomic stress test indicated that financial institutions as a whole could be considered strong and resistant to economic stress situations. Developments in profits and capital of each institution in these situations of stress varied showing more robust institutions than others.

For the bank, the rise in the US stock market reflected better expectations of the economy and the administration of the new government. As a result of these better expectations about the United States, the dollar appreciated against the major currencies of the world.

In terms of the European financial markets, the stock market had maintained a good general performance coupled with low volatility. The most volatile period of the last two years occurred after the referendum of U.K.

Regarding the monetary policy of the Japanese central bank, the short-term interest rate remained close to 0% or in negative territory. The yields of the Japanese Government Bonds (JGB) continued to show a normal behaviour with the guidelines of market operations where the interest rate had been set at -0.1% and the target on yields on 10-year bonds was 0%. In the following graph, you can see how the yield curve of the JGB was.

Graph 82. Long-Term JGB yields (10 years) and JGB yield curve. Retrieved 5th March 2018 from


As for the Japanese stock market, it had shown an upward trend thanks to the good global performance of the shares, mainly in Europe and the United States. Since the end of 2016 and in 2017, the Japanese index had shown a stable behaviour without major changes.

The amount of credit risk of the main financial institutions had shown a downward trend. This was the result of improving the quality of the loans, which reflected a better dynamic of the economy in general. The following graph shows the decreasing trend of the risk of the main banking institutions.

Graph 83. Credit risk among financial institutions. Retrieved 5th March 2018 from


In the second report of the year in October 2017, the bank noted that global volatility in the main financial markets remained low, along with positive but moderate economic growth, despite geopolitical tensions with North Korea and the United States. There were no significant changes in capital flows including flows destined for emerging markets.

In Japan, the monetary policy followed an accommodative path and the trend of loans granted had slowed due to a higher cost of loans in foreign currencies. Regarding the local financial market, the rate of growth of loans grew to 3%, and the demand for loans by small companies had improved.

The bank did not observe any financial imbalance in the assets and the financial entities. They continued using accommodative policies granting loans without major restrictions to the economy.

The real estate market showed no signs of overheating, but there was evidence of high prices in some places in Tokyo. In the stress scenarios applied by the central bank, if the financial market faced complex situations and the risk spread to the real economy, this could affect the real estate market.

The bank also did not observe greater imbalances in financial institutions or economic activity, so most commercial banks had good ratios between debt and capital, which made them resistant to stress situations as in the first delivery of 2017. The banks were robust in capital and liquidity regardless of the scenario in which the economy was located, due to a good rebalancing of the portfolios of the banks that have faced a greater demand for loans.

The benefits of Japanese banks have been decreasing, but this is happening at a general level in developed economies due to an environment of low-interest rates which was implemented by banks after the 2008 crisis. In Japan, they have also seen a decrease in the margins of profit of the banks due to the high competition between banks by the market, and in recent years have seen more exits of the market than entries of new banks.

A significant risk that the bank observed was the continuation of low-interest rates in the main economies in the world, which led to greater liquidity in the markets and investors taking more risk than desired by the bank’s board. Given the above, stocks in the United States and Europe had reached record highs, and valuation indicators P/E (Price/Earnings ratio) had reached historically high levels.

As in the April report, the volatility of the financial markets was low, which could mean an excess of market confidence at current valuations and an excessive risk taken by investors, coupled with greater investor leverage.  All this generated a greater risk than desired by the bank’s committee.

In terms of financial markets, the short and long-term interest rates remained stable as programmed by the monetary easing policy and share prices had risen moderately. The short-term interest rate remained in negative territory.

The Yen had depreciated against the Euro reflecting a decrease in uncertainties concerning political situations in Europe, and expectations of a reduction in the monetary policy of the European Central Bank (ECB). On the other hand, the Yen remained stable against the Dollar since the second half of 2017 and some investors expected an appreciation against the Dollar due to some political risks in the United States.

Finally, in the bank’s report, the committee stated that financial institutions had continued to increase their balance sheets reflecting an increase in deposits and the rebalancing of portfolios including risky assets. Assets and total debts of financial institutions increased to 236 trillion yen since 2012, and the portfolio was continuously balanced between bonds and shares.

In conclusion, with the reports issued in 2017 by the Bank of Japan, the financial system was resistant to stress situations tested by the bank, although as in most countries there are banks with better asset quality and portfolios, there are always recommendations for some specific banks. The economy grew moderately during 2017, and monetary policy remained accommodative to encourage banks to grant more loans and thus generate more growth which in the medium term would lead to inflation at 2%.

As mentioned previously, the bank saw some risks in international markets due to a euphoria unleashed, mainly in the stock markets, which could generate imbalances in the real estate sector of the economy. Regarding the Yen with respect to other currencies, the behaviour was stable during the year, although there were slight depreciations concerning the Euro and the Dollar.


Forex Educational Library

Japan’s Economic Outlook

Japan’s economic outlook

Category: Fundamental analysis, Intermediate, Currencies, economic cycles, Monetary Policy, Economy, Macroeconomics, Central Banks.

Key Words: Central Banks, Monetary Policy, Bank of Japan, Projections.

At each meeting of the bank’s board, a review is made of the state of the Japanese economy, the projections for the current year and the next two years, and the risks to which the economy is exposed both internally and externally.

In the April 2017 report, the board concluded that the economy would continue its positive trend growing above the potential stipulated by the bank, due to better internal financial conditions, some government stimulus and greater global economic growth. The bank was explicit that the expected growth in 2017 and 2018 would be higher than in 2019 due to a cyclical slowdown in fixed investment in business and an increase in the consumption tax that had already been programmed.

As global growth had generally improved, Japanese exports had shown an upward trend, contributing to economic growth. Private consumption had also been resilient due to a better outlook in the labour market with better employment rates and higher wages.

As already mentioned, the bank expected that by 2019 the local economy would slow down a little due to a slowdown in domestic demand reflecting the closing of the cycle of expansion in business investment in addition to the increase in consumption tax since that year.

Regarding inflation, the annual change in the CPI (Consumer Price Index) excluding fresh food continued to show better figures than in 2016 with a clear upward trend thanks to a better performance of the economy and an increase in expectations medium and long term. But even the price growth is not as strong as the bank would like so they followed the price index with some caution.

The annual CPI for April excluding food and energy was close to 0%, so the bank was still expectant that the price index was far from the target rate of 2%.

Regarding monetary policy, the bank indicated that it would continue to apply Quantitative and Qualitative Monetary Easing with the Yield Curve control, with the objective of using it until inflation hit 2% so that the short-term interest rate would remain in negative territory.

Inflation could reach 2% in the medium and long-term, but not in the short term due to the weak behaviour of the main price indices. It was estimated that in the medium and long term it could reach  2% due to better economic growth rates added to energy prices that have been rising in recent years. In addition, the policy of monetary easing continued to drive the supply of credit and liquidity to the market so that inflation continued to rise to the bank’s target figure.

Also, the unemployment rate continued to decrease showing figures between 2.5 and 3%, so the labour market was narrowing which could generate an increase in the nominal wages of people, which in turn could lead people to consume more and this would boost inflation. The following two graphs show the main projections of the members of the committee and the expected behaviour of the CPI until 2019.

Graph 77. Forecasts of the majority of Policy Board Members. Retrieved 27th February 2018 from


 Graph 78. CPI (ALL ITEMS LESS FRESH FOOD. Retrieved 27th February 2018 from


In the July report, the committee stated that the path of economic growth was still positive due to the already exposed factors of a better global panorama and incentives created by the government to stimulate the local economy.

Regarding inflation, there were negative signals that showed a weak CPI (excluding food and energy prices), being in figures between 0 and 0.5%. The bank indicated that it could be due to the caution that the companies had at the time of fixing the prices and the wages of their workers. This behaviour of the companies caused expectations to decrease somewhat on inflation in the medium and long-term. The bank stressed that for inflation to reach 2% companies had to be more determined when setting prices and wages.

What was driving inflation in recent months were energy prices due to higher global demand for fuels and the agreements reached by OPEC to sustain oil prices, which is why the bank was concerned that the other components of the prices were not contributing to the rise of the recent CPI.

Due to the weakness of inflation, the bank decided that it would continue with its policy of monetary easing until inflation was close to levels close to 2%, so that short and medium-term interest rates would remain in negative territory. In addition, the financial market continued to offer credit facilities to the market.

Despite the weak performance, in the bank’s projections, it was estimated that in the medium and long-term the inflation rate would be at 2%, but the projections had fallen slightly on this variable for the next two years.

In the October 2017 report, the bank’s committee continued to observe a positive performance of the economy due to higher exports thanks to the better performance of the world economy throughout 2017.

In terms of domestic demand, fixed investment in business had followed a slight upward trend with better profits from companies and better expectations of entrepreneurs on the Japanese economy.

Private consumption continued to grow moderately, thanks to the better performance of the labour market. There were good rates of job creation and wages rose slightly. Public investment had also had positive behaviour during the last quarter, but not spending by households that had shown flat figures throughout the year.

Looking at the financial conditions, the outlook did not change with respect to the two previously issued reports, since the short and medium-term rates remained in negative territory. Financial institutions were still willing to lend to the market, and corporate bonds were still well received by the market, so the bank continued to observe the accommodative financial conditions.

Although inflation continued to rise slightly as in mid-2017, this behaviour was mainly explained by the rise in fuel prices and energy in general. The weak behaviour of the CPI excluding food and energy was due to the little increase in prices of companies as well as wages and a mobile phone market increasingly competitive in prices.

If you compare the projections that the bank had in October with the projections at the beginning of 2017, the CPI showed a weaker than expected behaviour, but it was expected that in 2018 and 2019 inflation would have more positive figures as shown in the following graph.

Graph 79, CPI (ALL ITEMS LESS FRESH FOOD, Retrieved 27th February 2018 from


The reasons for a better performance of the CPI for the following years should be given thanks to better conditions in the labour market, better performance of the economy in general and better market expectations. The graph shows that inflation bottomed out at the end of 2016, showing deflationary signs.

The risks faced by the Japanese economy according to the bank were:

  • New regulations implemented in the United States and economic performance will directly affect global growth
  • Geopolitical risks
  • The Brexit negotiations
  • The problem of the European debt

These factors could affect the decline of the Japanese economy due to its direct involvement in world trade. The following graph shows the bank’s projections at the October meeting.

Graph 80. Forecasts of the majority of Policy Board members. Retrieved 27th February 2018 from


If these projections are compared with those made at the beginning of the year and July, expectations for 2017 and 2018 improved and remained the same for 2019. That shows the good performance of the economy and a slight recovery of inflation, but as the bank reaffirmed that recovery was not robust since it was mainly based on energy prices. The other components of the CPI did not yet show positive figures, so the bank expected 2019 to be close to 2%.

As long as the inflation rate was not close to 2%, the monetary easing policy would continue. That would include negative interest rates and acquisitions, and corporate bonds to provide liquidity to the market and thus achieve better growth rates. This would encourage companies to be more aggressive in its increases in prices and wages of workers, which was not as strong as would be expected from a narrow labour market, although they did rise during 2017.

The following graph shows the CPI excluding food and energy which shows that the figure during 2017 was well below 0.5% which is negative and gives the reason why the bank committee was concerned because the basic items of the index showed a very weak behaviour.


Graph 81. Chart 38, CPI. Retrieved 27th February 2018 from


Forex Education Forex Educational Library

Organisation of the European Central Bank

Globalisation has led to an integration of the various aspects of people’s lives from consumer habits to cultural aspects. The economy has not been indifferent to this phenomenon and the relations between most countries have been internationalised so that there is more and more dependency between them and for that reason greater co-operation between governments and between the central banks of each country.

There are more and more processes of regional integration, which has led geographically close countries to eliminate barriers to trade between each other and generate an economic bloc that is more competitive with the rest of the world. But not all forms of integration are equal, there are some deeper ones that allow macroeconomic policies to be co-ordinated and create a single currency and other unions that simply reduce trade barriers between countries without going beyond a privilege in trade with certain countries.

The European Union has developed a legal and political system that promotes continental integration through common policies that cover different spheres of European society, although the origin of this union is especially economic. The form of integration was a monetary union where a single currency was created to facilitate transactions between countries, but some countries belonging to the European Union avoided giving up their control over their currency and therefore did not adopt the Euro as a transaction unit.

In order to achieve monetary union, certain requirements of fiscal homogeneity need to be met in order to synchronise their macroeconomic policies, which is why some European countries have first had to meet some public deficit targets in order to be part of the integration. Being part of a monetary union, the member countries give part of their sovereignty to the European Central Bank, in charge of issuing the common currency and fixing the monetary policy of the economic union.

The countries that make up this economic agreement have:

  • Preferences among members to boost trade within their borders.
  • Elimination of trade barriers for members of the agreement.
  • Common external protection.
  • Free mobility of capital, people and productive factors
  • Economic policy coordination
  • Unique economic policy

The first historic step for the consolidation of the European Central Bank occurred in 1998, where the decision was made to build an economic and monetary union with free capital mobility within Europe, a central monetary authority and a single monetary policy within the European area. But before formally taking the decision two previous events had occurred that allowed the creation of the bank.

  1. In 1990, free capital mobility is allowed among some European countries, as well as greater co-operation among central banks, which allows a convergence in the economy of several European countries.
  2. The European Monetary Institute (EMI) was established in 1994, central banks were prohibited from continuing to grant loans, monetary policy co-ordination was further increased, economic convergence followed and the establishment of central bank independence to take the necessary measures for the good performance of the economy.

Already in 1999 stronger steps were taken for the monetary and economic union, such as the introduction of the Euro, the establishment of a single monetary policy set by the European System of Central Banks (ESCB) and the conversion rates were set.

Since the 1st of January, 1999 the European Central Bank has been responsible for conducting the monetary policy for the eurozone consisting of 19 state members. To be part of this union, each country had to comply with certain economic and legal criteria. The following chart shows the main stages of the European Central Bank.

Graph 74. Stages of the European Central Bank.


The European Central Bank has a legal status under international law and is considered an international institution. The Euro system is composed of the European Central Bank (ECB) and the National Central Banks (NCBs) of the countries that adopted the Euro. The Euro system and the European Central Banks system will continue to co-exist as long as there are members of the economic union who have decided not to adopt the Euro. The following chart shows the member countries of the eurozone.


Graph 74A. Euro Area 1999-2015. Retrieved 16th February 2018, from



The main objective of the bank and its monetary policy is to maintain price stability. As complementary objectives, the bank must help the economies of member countries in their growth and in the dynamics of the labour market, but without these variables diverting the main objective of keeping inflation under control.

For the bank, price stability is defined as an annual increase in the Harmonised Index of Consumer Prices (HICP) for the entire eurozone below 2% and a long-term target of 2%.



The European Central Bank has four major subdivisions that make all the decisions to fulfil the bank’s mandate.

  • The Executive Board
  • The Governing Council
  • The General Council
  • The Supervisory Board


The Executive Board

All the members of the board are appointed by the European Council. Each member is chosen for a period of eight years without the possibility of renewing. The board meets normally every Tuesday and is composed of:

  • The President
  • The Vice-President
  • Four other members

The committee is responsible for the implementation of the monetary policy defined by the governing council and the instructions given by the National Central Banks (NCBs). It is also in charge of the daily management of the bank and prepares the meetings of the governing council.


The Governing Council

It is the decision-making body of the bank, composed of six members of the executive committee as well as the governors of the central banks of the 19-member countries of the Euro-system. It is chaired by the president of the ECB. They meet every six weeks and publish the minutes of the meetings with all the necessary information four weeks after the meeting. In total it is composed of 25 members with the accession of Lithuania in 2015 and there is a rotation of the votes in the meetings as follows:


Rotation of voting rights in the Governing Council



Graph 75. Rotation of voting rights in the Governing Council in 2018. Retrieved 16th February 2018, from

The responsibilities are to define the monetary policy of the euro area and in particular to establish the interest rate at which commercial banks will be given resources, in addition to the supply of Euro-system reserves.


The General Council

It is composed of the president of the ECB, vice president of the ECB and the governors of the 28 National Central Banks (NCBs) that belong to the European Union, where 19 countries are of the euro area and 9 countries of non-euro areas. Other members who attend the meetings, but without the right to vote are the president of the Council of the European Union and members of the European Commission.

The general council carries out the tasks assumed by the European Monetary Institute (EMI) that the ECB should execute as the last phase the economic and monetary union since not all the member states adopted the Euro. Its functions are the collection of statistical information, preparation of the annual report of the ECB among others. This body will be dissolved when all the members of the economic union assume the same currency.


The Supervisory Board

The supervisory board meets twice a month to discuss, plan and carry out supervisory tasks of the bank’s departments. It consists of, the president appointed for a period of 5 years, vice president elected from among the members of the executive board, four representatives of the ECB and representatives of national supervisors

In conclusion, there is a certain similarity between the way monetary policy decisions are made between the European Central Bank and the US Federal Reserve since it is done through voting by the governors of the banks that make up the central bank and take turns the votes in the meetings. The difference is that the rotation of the votes of the districts that make up the Federal Reserve is annual while the votes of the banks that make up the ECB are rotated monthly as shown in the graph above.

Regarding the mandate of the central banks, there is a greater similarity between the ECB and the Bank of England since both have to maintain price stability as its main objective, and the objective of the annual growth of inflation is 2%. Although they also worry about economic growth and the unemployment rate, these objectives are secondary. While for the Federal Reserve the three variables are equally important, so by mandate they are responsible for maintaining low unemployment rates, stable economic growth with good growth rates and an inflation rate that is close to 2%.

Forex Education Forex Educational Library

Bank of Japan

The Bank of Japan is the central bank of Japan. It is a juridical entity established by the Bank of Japan Act. It has no governmental character nor is it a private corporation. The law states that the bank’s objectives are to issue banknotes, carry out monetary control and monitor the stability of Japan’s financial system. The law also stipulates price stability as the main objective of the bank which will contribute to the development of the national economy.

The Bank of Japan started its operations on the 10th of October 1882 as a central bank under the laws of that country. The original statutes were modified in 1942 due to the war situation and after this conflict ended, the bank’s regulations were modified again. In 1949 the Policy Board was set as the governing body and responsible for making the most important decisions of the bank. The law of 1942 was completely revised in 1997 and it was stipulated that the bank’s independence and transparency were fundamental pillars of the bank.

The organisation of the bank is divided as follows:

Graph 70. Organization Chart. Retrieved 15th February 2018, from


The Policy Board was established as the most important bank entity for decision making. The board examines the guidelines for monetary and currency control, establishes the basic principles to carry out the operations of the bank and supervises the fulfilment of the duties of bank officials.

It is composed of 9 people. The Governor who represents the bank and exercises general control over the affairs of the bank, two Deputy Governors who assist the governor and they control some matters of the bank, and six members of the Policy Board who serve as support for the Governor and Deputy Governors. They are also in charge of other matters of the bank.

Then there are the Bank’s Officers who are made up of the Governor, the Deputy Governors, the members of the board of directors, auditors, executive directors and counsellors. These officers are responsible for managing the operations of banks, to ensure that employees comply with the required tasks and assist in the tasks of the Policy Board.

Finally, there are the Departments, Branches, Local Offices in Japan, and Overseas Representative Offices. There are 15 departments, 32 branches and 14 local offices in Japan and 7 overseas representative offices

The bank is capitalised by 100 million Yen due to the bylaws, and 55% of the capital is subscribed by the government. The law does not grant the holders of the subscription certificates the right to participate in the management of the bank and in the event of liquidation they are only granted the right to request the distribution of the remaining assets up to the sum of the paid-in capital. Dividend payments in paid-up capital are limited to 5% or less each fiscal period.

The central objective of the monetary policy of the bank is the stability of prices. It was stipulated as an objective from 2013 that the maximum rate of annual growth of prices was 2%, this rate promotes economic growth and the well-being of the population. Price stability is important because it provides the basis for the nation’s economic activity.

In a market economy where there is a diversity of markets, individuals and companies make decisions about consuming, investing or saving according to the prices of goods and services in addition to the interest rates of the financial system. When prices fluctuate beyond what is expected, it is difficult for agents to make decisions and this may hinder the efficient allocation of resources and revenues.

The Policy Board of the bank decides on the basic stance of monetary policy in its meetings, discusses the economic and financial situation and then makes an appropriate guide for monetary policy operations. After each meeting, the bank publishes its evaluations of the economic activity and the price level, as well as the position adopted by the monetary policy in the short term.

According to the guidelines stipulated by the board, the bank controls the amount of money circulating in the economy, mainly through Money Market Operations. The central bank offers funds to financial institutions through loans that are backed by guarantees given to the central bank.

The meetings of the board of the central bank are held eight times a year and each meeting takes two days of discussions. At each meeting, the members of the board of directors discuss and decide on the guidance of future operations in the money market. Monetary policy decisions are taken by majority vote of the nine members of the Policy Board.

One aspect that has become widespread but is still important is the independence of the central bank since the decisions made by the bank have an impact on the daily life of the Japanese people. The bank and its employees conduct economic and financial system research to be well informed about the most appropriate decision on monetary policy.

Forex Educational Library

Money and Monetary Policy


Coming from the Latin word that defined the Roman coin denarius. Money is, in general terms, the preferred means for the exchange (charge vs. payment) of goods and services, likewise cancellation and/or acquisition of rights or obligations.

It can be associated with other functionalities or uses:


Money facilitates any exchange of goods and services among economic agents and reduces transaction costs. Any economic system with a high degree of specialization and division of labor uses money as a medium of exchange or payment of goods produced and services provided by different individuals or persons.

An economic system that excludes money as a medium of exchange of these transactions, involves the application of mediation type barter, time banks

The following properties are required to achieve the present functionality:

  • Homogeneity: The units must be identical or close.
  • Divisibility in units small enough to be able to exchange any good.



To be able to recognize it as such, money must satisfy the characteristics of durability, allowing people to keep or accumulate wealth through savings.

Money brings the advantage of its liquidity, understanding this in its broadest possible terms, i.e., the temporary capacity that offers any good to be converted to money, without losing its value in commercial terms over time.

Time can affect the value of money in terms of purchasing power and its relation with market prices in its three temporalities: past, present, and future.



Environment-related to the setting of market prices of goods and services, as well as the control of accounts (accounting).

The monetary unit defines how to measure the expression of the value or market price. Each economic zone shall define its official monetary unit ; $; £


There are several kinds of money varying in liability and strength. When there was ample availability of metals, metal money came into existence later it was substituted by the paper money. According to the needs and availability of means, the kinds of money has changed.


Commodity money is generally accepted as means of payment or exchange and is purchased or sold as an ordinary asset. Gold and silver have been the most common precious metals used as money. The value of this kind of money comes from the value of the resource used. It is only limited by the scarcity of the resource.

Some features: Durability; divisibility; transportable; homogeneity; limited offer…

Ex: gold coins, bread, metal, stones, tea, camels…



A term used to denote a specific form of currency, not bound to any metal supporting it. A significant amount of the paper currency available all over the world is fiat money.  Fiat money is backed by national governments as the recognized official medium of payment. Fiat money does not hold any inherent worth of its own, and they do not have the support from any form of reserve, as well. It is operating solely on faith, like the sterling used in Scotland. Nowadays, Fiat money is the basis of all the modern monetary systems. The real value of fiat money is determined by the market forces using demand and supply.

The fiat currency is also sanctioned by the Government for payments of taxes or other legal, financial obligations.



Is conventionally maintained on a trust. The fiduciary normally retains the assets for a certain beneficiary, who could even be an executor of a will. Payments of fiduciary money could also be made in commodity money like gold or fiat money. Bank Notes and Checking Accounts are examples of the conventional forms of fiduciary money which, in this case, are provided by Banks.

Fiduciary money can be obtained from banks in the form of credible promises. These promises are eligible to be transferred and do perform the functions of conventional money.

The present-day world attaches higher importance to the token money whose variations are fiduciary money and fiat money, which differ significantly from commodity money.

Ex: Bank Notes, checking accounts…



It´s possible to describe a commercial bank like an entity that essentially deals with loans and deposits from major business organizations and corporations. Are the most important components of the whole banking system.

The Central Banks and its functions

A Central Bank is a public entity, autonomous and independent of the Government, responsible for the monetary policy of a country.

There´re seven examples of important Central Banks around the world:

Among its functions we can highlight:

  • Establishing the purposes and instruments of monetary policy and implementing.
  • Setting the official interest rate.
  • Centralizing and controlling economic operations abroad, especially making the purchase and sale of foreign currencies that are necessary Managing the country´s Foreign Exchange and gold reserves.
  • Supervising the financial system to ensure its proper functioning and that there are no problems that may affect the economy as a whole.
  • Authorizing the issuance of bills and coins in exclusivity à Controlling the nation’s entire money supply.
  • Acting as a bank of commercial Banks and Government bank.

Since it is responsible for Price stability, Central Banks must regulate the level of inflation controlling the money supply, through the use of monetary policy. A Central Bank performs open market transactions that either inject liquidity into the market or absorb extra funds, directly affecting the level of inflation.

Money Creation

The majority of money in the modern economy is created by commercial banks when making loans.

Money creation in practice differs from some popular misconceptions — banks do not act solely as intermediaries, lending out deposits that savers place with them, and they do not ‘multiply up’ central bank money to create new loans and deposits, either.

The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘Quantitative Easing.’

Quantitative Easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

The aim of quantitative easing is to encourage spending, keeping inflation on track to meet the Government’s inflation target.

QE works, i.e., when we buy gilts, it pushes up their price and so reduces the yield (the return) that investors make when they buy gilts. This encourages investors to buy other assets with higher yields instead, such as corporate bonds and shares. As more of these assets are bought, their prices rise, pushing down borrowing costs for businesses, encouraging them to spend and invest more. We also buy a smaller amount of corporate bonds, which makes it easier for companies to raise money which they can then invest in their business.

Money creation processes by the aggregate banking sector making additional loans



Limits to broad money creation

  • Banks themselves face limits on how much they can lend. 3 Constraints:
  1. Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.
  2. Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.
  3. Regulatory policy acts as a constraint on banks’ activities to mitigate a build-up of risks that could pose a threat to the stability of the financial system.
  • Money creation is also constrained by the behavior of the money holders: households and businesses. Households and companies who receive the newly created money might respond by undertaking transactions that immediately destroy it, for example by repaying outstanding loans.
  • The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the monetary policy affects how much households and companies want to borrow.

That occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy. As a result, the Central Bank is able to ensure that money growth is consistent with its objective of low and stable inflation.

 Money Offer

The total amount of existing money, also called money supply, in an economy consists of cash in the hands of the public and the deposits held in the banks.

That amount of money grows or decreases as a result of bank credit and preference for the public’s liquidity, which together determine the value of the monetary multiplier.

The money supply, M, is, therefore, the result of the expansion of the base money, M0, due to the effect of the monetary multiplier m:

In the money multiplier process, the key is in a very important proportion: the ratio between the reserves of the banks (they correspond to their deposits in the central bank) and the deposits of the public in the banks plus other liabilities.

Banks want to keep that ratio at a certain level, partly to have liquidity with which to deal with withdrawals of funds from their customers and operations with other banks, but, above all, because their central bank, usually, requires them to maintain this relationship above a minimum level.

Depending on the central bank they have different names:

  • ECB → Mandatory minimum reserves
  • FED → Required or mandatory reserves

Therefore, banks keep a slightly higher proportion than the mandatory minimum, so as not to run the risk of breaking that coefficient. Although,  they are not interested in keeping a liquidity level too high because it would mean a loss of return that’s obtainable if they’re able to spend that excess liquidity to buy profitable assets.

Then, when the volume of reserves of banks increases above the mandatory minimum ratio, bank entities may grant credit to the private sector and the public sector. The opposite occurs when their volume of reserves is decreased.


An example to clarify this issue:

Let’s assume that the proportion desired by the Central Bank in a certain country is 2%; that is, for every 100 monetary units in deposits, banks need to hold two units in liquid assets.

Imagine that yesterday all banks fulfilled that proportion, and, today, the volume of liquid assets on a certain bank has increased by 100 monetary units. Now, its coefficient is higher than the 2% desired, therefore, the bank will be interested in placing all or part of that surplus, awarding, for example, a credit to the private sector.

How will the maximum amount be known? If the numerator has increased by 100 monetary units and the quotient has to remain 2%, the denominator is allowed an expansion of up to 5,000 monetary units. The process of creating money and the process of creating credit have been launched, the final result of which is a high multiple of the initial operation.

We should understand that the amount of money in circulation varies at every moment, due to the thousands of simultaneous operations of creation, and destruction. It is interesting to realize that Central Banks control this creation process, and for this purpose, it needs a mechanism to increase or reduce the reserve account of the banks and a mechanism to regulate the creation of credit when the reserves grow, as previously commented. It is here when the so-called Monetary Policy is applied.

Each central bank has its own objectives. As is the case of the ECB, whose sole objective is price stability through a low and steady inflation rate of less than or equal to 2% per annum. On the contrary, the FED pursues two objectives: price stability without a quantified inflation level, and maximizing employment, together with the sustainability of long-term interest rates.

The implementation of the monetary policy requires the use of one or several instruments for the creation and destruction of reserves, thus, establishing the initiation of a process of creation or destruction of credit and money.

Although they manage a wide set of tools, they can be summarized into three:

  1. A mechanism for withdrawing and conferring credit from and to the banks. This is the case of the periodic liquidity auctions by the European Central Bank.
  2. Open market operations: buying or selling public debt to banks. When a central bank purchases government bonds from banks, it injects liquidity into the system, and the opposite happens when the central bank sells public doubt to the banks. This is one of the main tools currently used by the FED. Remember the explanation of QE.
  3. And last but not least is the required minimum reserve ratio, where its decrease releases liquidity in banks and increases the amount of money. The opposite holds when there is an increase in the coefficient. It is important to take into account the limited widespread use of this tool. That’s because it usually causes large distortions on the bank’s liquidity.


Interest rate

The interest rate is a variable that is present in almost all decisions of households, companies, financial entities and Governments. These decisions refer to actions or consequences that take place at different times of time and therefore, the interest rate represents the price of time. We could interpret it as the prize that is demanded to delay the enjoyment of something from today until tomorrow or the premium that you have to pay to advance that enjoyment from tomorrow to today.

Although there are many types of interest, let’s focus on interest rates of assets and liabilities and financial operations; so we would be dealing with the returns obtained when lending or placing wealth in a financial asset or the cost of Debt.

As already mentioned, central banks usually use two instruments to increase or decrease the circulation of liquid assets or reserves held by banks:

  • The granting of credit to banks →
  • Open market operations →

Central banks usually manage these instruments through a very short-term interest rate. Following the examples of the previous central banks, it is known that the ECB periodically announces an interest rate of the main financing operations that serves as a guide to the banks to the banks for the weekly credit auctions. The extent of that interest rate and its expected future changes will be a useful indicator of the expansive or contractive nature of monetary policy. An increase in that interest rate is indicative of a tightening of monetary policy, that is, a liquidity contraction and a higher cost of central bank credit, as well.

In the FED’s case, this decision sets the federal funds rate, indicating the interest rate at which it is willing to buy public debt to the banks to provide them with liquidity or,  to sell it, thus, withdrawing liquidity. Therefore, that rate and its expected or announced changes will also imply changes in the sign of monetary policy.

However, the central bank controls the short-term interest rate, but families, companies, and Governments are mainly affected by the longer-term rates. This means that monetary policy has a limited, but real, effectiveness on financing conditions.

Therefore, a better understanding of the role of monetary policy in setting interest rates establishes:

  1. In very short terms, interest rates are usually controlled by the rate that the Central Bank uses to implement its monetary policy. If, as an example, we say that the eurozone banks are receiving ECB weekly credits at 2%, a logical assumption will be that the next week’s interest rates will be close to 2%, except if excesses or significant liquidity deficiencies
  2. manifest the Monetary authorities can also influence the longer-term rates, announcing their purposes about future interest rates. That would be the case, for example, when they announce they will keep their interest rates very low for one year.
  3. Authorities may also influence long-term nominal rates if they announce a feasible and credible inflation target.

Central Banks, at best, can only control nominal rates, because the expected rate of inflation will depend on the expectations of economic agents.

In a simplified way, the likely evolution of the relationship between short and long-term types in a country is as follows:

If we take as starting base a situation of a balanced performance of the economic activity, with normal market returns and subsequently, the economic activity accelerates, along with inflation expectations, its likely outcome will be a rise of the long-term interest rates.

Under these conditions, it is likely that the central bank decides to practice a restrictive monetary policy, and therefore, a rise in the interest rates in a very short time.

This monetary policy will end up moderating production and prices. As the markets anticipate this result, the long-term rates will fall again and the central bank will be able to reduce the restrictive nature of its monetary policy by returning to equilibrium.



Inflation shows the upward or downward movements of thousands of prices, which implies the difficulty in identifying the continuous and sustained changes in the set.

However, the accuracy shown is relevant because a price variation may arise from many possible causes. In the same fashion, it happens on the movements and one-time changes in many prices,  and, also, on the seasonal changes. But beware: a continued and sustained rise in the overall level of prices will not happen without any visible cause.

Who is worried about inflation?

  • Governments
  • companies
  • workers
  • customers


  • A rise in domestic prices not compensated by the depreciation of the currency produces a loss of competitiveness with other nations.
  • Price raises may alter the distribution of income and wealth, damaging agents who have not been able to anticipate or protect against that. It is for this reason that countries suffering from high and variable inflation also experience episodes of malaise and social conflicts.
  • Inflation can extend over time, generating expectations that often auto-fulfill.
  • It is a non-democratic and regressive tax on money.
  • If inflation is large and variable, it may generate large inefficiencies.
  • Stopping inflation, once installed, is usually difficult and costly.

What is the cause of inflation?

If we take supply and demand as our base assumption, many possible causes can be identified, some on the demand side, such as the increase in consumer income and others on the supply side, such as an increase in the productive factors or the tax levied on the product.

Please note that a significant rise in prices will reduce the purchasing power of money,  which leads to a monetary concentration.  That will, in turn, raise interest rates and slow down the growth of production and prices. However, this will not happen if the growth of money supply is accelerated, which reduces the real interest rates, and, consequently, founds the increase in aggregate demand (consumption, investment, public expenditure, exports, and imports).

Faced with this reality, the following we may state the following:

  • If inflation is not accompanied by growth in money supply, a larger growth on some of the components of aggregate demand or costs (labor, raw materials) will generate a one-time price increase.
  • The creation of an adequate money supply is a necessary condition for any sustained growth of the general price level.

In addition, it can also be a sufficient condition for inflation since if economic agents receive more money than they need to finance their transactions, they will spend it, and in that process, they will generate an increase in the demand for goods and services and a rise in prices.

  • Not all changes in money supply cause a rise in prices: Companies whose sales grow will need a larger balance of money in their possession, money the company won’t expend so that it won’t produce price increases.
  • Therefore, the following approach arises:

Inflation is always a monetary event caused by the excessive growth of the amount of money concerning what is necessary to finance the real growth of the economy. That explains why Central Banks are committed to controlling inflation: because they control the amount of money.

To understand the relationship between Central Banks and inflation, it should be conceded that usually, the monetary authority of a country establishes the objective of its monetary policy in terms of the desired inflation rate (*). This rate of inflation that is usually low, stable and positive, will be the one that the monetary authority tries to achieve in a relatively long term and in this way avoid an erratic monetary policy. Sometimes they include a goal regarding the rate of growth of the gross domestic product, trying to match the potential growth rate of the economy (y*), compatible with a complete use of resources, so that below (left) it, costs tend to be reduced by the pressure of unemployment and above (right), costs tend to increase due to over-use of resources. Therefore, observing the following table, it is understood that point A is the one desired by the monetary authority, as previously mentioned.

If the economy is at point E, the Central Bank will practice an expansive monetary policy and keep interest rates low. When approaching B, it will probably raise the interest rate, with the objective of preventing the economy from moving to the right of y* (before arriving at A) given the slowness of the effects of monetary policy.

In C the monetary policy of the Central Bank will be clearly restrictive, in an attempt to return to A.

In D, the Central Bank will be faced with several alternatives: If it pursues the objective of inflation the action will raise interest rates with the consequent accentuation of the recession. Establishing here an observation beacon for monitoring the reaction of economic agentsI.e. The fear that trade unions might push for higher wages increases the likelihood of an interest rate increase. This explains the reason for the reaction of the Central Banks to the rise in costs such as oil or ad valorem taxes even if they produce one-time price increases  → The fear that that may turn into wage increases, even more so if they use automatic indexing on wages.

An inflation like C is attacked by the use of a restrictive monetary policy, and a reduction of the rate of growth in production is the first parameter to be affected, which will shift to F, and solely after a while, it will end up achieving the objective: A.

Inflation is maintained around the desired level * through an expansive monetary policy but at a very moderate level, and it must be accompanied by other measures such as:

  • The prohibition for the central bank to finance the public deficit, thus avoiding the excessive growth of the amount of money.
  • A monetary exchange rate policy compatible with the monetary restriction
  • Salary moderation as a countermeasure, to avoid more rigorous monetary restrictions and its negative effects such as unemployment and recession before inflation can be reduced.
  • Credibility and perseverance in government policy, because if Government’s announcements lack these attributes in the eyes of the economic agents, the moderation of inflation will be a lot more difficult.


Value: To be able to add the production of heterogeneous goods and services and express them in a common monetary unit: Pound Sterling, Dollar, Euro.

Final: To avoid the problem of the double accounting of goods that become part of the production of other goods and services, such as raw materials and intermediate products. GDP equals added value.

Of Production: Not of sales.

Of goods and services: But only the remunerated ones, so leisure, study, bricolage… and the legal ones are excluded.  Underground economy and the illegal activities are not included: drug trafficking …

In a country: Region or city. It will depend on what you want to cover.

During a given period: (one quarter, one year …). Transactions carried out with goods produced in the past are not included.

At market prices: (sale to the public) including net indirect taxes (VAT).

To understand GDP, it is necessary to know other concepts related to:

There are three procedures to calculate the GDP of a country:





Kind regards



Forex Educational Library

Monetary Policies in Open Economies


The central bank and the government have tools to accelerate the monetary policies or contract the economy such as the interest rate, public spending, the amount of money in the economy among others. But when an economy is exposed to international trade some factors can have undesirable effects on the local economy. That is why when the authorities are going to intervene in the economy they not only think about local theoretical models, they also must think about how these measures will affect trade with other countries and how the trade balance of the country will turn out. Not only will the trade balance end up affected, but also the exchange rates with other currencies and therefore the purchasing power of people, so it is essential to analyze the effects in an open economy of economic intervention.

With globalization, economies face various challenges as seen in the article Globalization and its risks. One of the most important decisions faced by central banks and authorities is the determination of the exchange rate and the economic policy that each country will take depending on the objectives pursued by the government and the central bank. Economies that are exposed to international trade and thus to globalization are called open economies. Open economies can be affected by internal factors such as public spending or the level of consumption or external factors such as the depreciation of foreign currencies or consumption in other countries.

In the case of the global crisis of 2007, this relationship between open economies was evident, because when the domestic market of the United States was depressed, other countries such as China and European countries were affected because their exports decreased and therefore the income of its inhabitants. In the next part of the article, we will show how some variables affect open economies. The first will be to analyze how a variation in the demand for domestic production affects a free economy.

If at a given moment the government decides to increase public spending given the economic situation of the country this will boost domestic demand and the production of national goods. According to some analyzes carried out by economists, it has been observed that the increase in public spending has a multiplier effect on the rise in production and the level of consumption. But the unwanted result of the increase in public expenditure is the generation of a deficit in the trade balance.
The above is generated due to the increase in the consumption of imported goods, but exports are not affected by domestic consumption, which leads to a deficit. Unlike what would happen in a closed economy, public spending affects production to a lesser extent because, as mentioned above, people will consume more, but not necessarily from local production, so a government’s effort might result in a minimal boost to the economy. In summary, an increase in public spending in open economies will generate a trade deficit and a small effect on local production due to the rise in demand for foreign goods.

It is a fact that the more open an economy is, the lower the effect on production will be and the greater the negative effect on the trade balance since demand will increase more on the part of foreign goods. Given the above in open economies, it is unattractive monetary policies to get the economy out of a recession based on demand alone.

Now an increase in the production of foreign goods and its effect on local economies will be considered. This increase in the production of foreign goods could be due to a rise in the public expenditure of the foreign country or another positive shock for overseas production. If foreign production increases, this is also linked to a rise in foreign demand including foreign goods. Therefore, it increases the exports of the local country to respond to this increase in foreign demand, which increases local production and domestic demand. In some cases, imports may also increase due to the rise in local demand, but it will be less than the increase in exports and as a result, it will be a surplus in the trade balance.

So far, two necessary conclusions have been presented:
• An increase in domestic demand causes an increase in domestic production but affects negatively the trade balance. This effect applies to a rise in public spending, tax reduction, or a net increase in consumer spending.
• An increase in foreign demand causes an increase in local production and a better trade balance thanks to the incentive to exports.

The higher the commercial relations between the countries, the higher their interactions and they will be more exposed to the shocks that each economy has. These basic conclusions can be observed by what has happened in recent years in some countries. In most OECD countries, there was a strong expansion of the economy in the second half of the 1990s, followed by a sharp recession in the first years of the 21st century. An explanation for this similar behavior in the OECD steps was the commercial relations between these countries.

These commercial interactions make difficult the tasks of those responsible for the monetary and monetary policies of a country since not only must local variables be considered, they must also analyze how the main trading partners of the country will respond. No government likes to see a trade deficit with other countries since this means that new debt is accumulated with other nations through imports and if there is an increase in this deficit the debt will grow with their respective interests. But in some cases, it is better to incur a deficit in the trade balance. If on a recessive economy a government waits for other countries to take measures to overcome this crisis, and thus increase exports, it may occur in some cases that no country acts and the crisis might become worse for all the countries involved.

In order for governments not to wait for the responses of other states, in theory, they should coordinate their macroeconomic policies to increase their domestic demand simultaneously as well as production without entering larger trade deficits as imports increase at the same pace than exports. At this point, it is important to clarify that if they coordinate their monetary policies, the deficit of the balance between them does not increase, but it is likely that the deficit increases concerning other countries of the world. This coordination between economies is not rare to see. Many countries, especially the most powerful ones, meet periodically to analyze their economic situation and try to reach a better point together.

But like OPEC, full cooperation between member countries is difficult since some countries could benefit more than others and not work in the same way. In other cases, there will be countries that are not in recession, so they will not have incentives to cooperate because if they do this, they will see their increased deficit with countries outside the agreement. Besides, each state can have problems such as fiscal deficits, issues in the exchange rate among others, so to reach a common understanding on the solutions for each country will be complicated.

Another important variable in open economies is the nominal exchange rate. Some countries could benefit from depreciating their currency to be more competitive in their exports such as China, a country that many have accused of having an artificial rate that does not respond to market forces. This topic is analyzed in the article China and its economic predominance.
If the government or central bank of a country takes measures that lead to a depreciation of its currency in nominal terms, it will end up affecting the real economy since it will have effects on the trade balance and the production of the country in question. Depreciation will change the trade balance since exports will increase since with a depreciation they will receive more income in nominal terms and their costs will remain the same and this will be an incentive to produce more for external consumption. Another effect is the reduction in imports because they will be more expensive to acquire in the country which will transfer the consumption of external goods to local goods.

To make the trade balance better, after a depreciation, exports must increase enough, and imports must decrease enough to offset the rise in the price of imports. The effects of a real depreciation are very similar to the effects caused by an increase in the demand for goods in a foreign country. A depreciation causes an increase in net exports, which causes an increase in local production and a better trade balance. The problem of depreciation is that they affect the well-being of people due to the rise in the cost of foreign goods, so this type of policy is not well received by people as it increases the cost of their goods.

In the following part of the article, the different types of systems of change will be exposed. There are two main types of methods of change. The flexible exchange system allows the exchange rate to fluctuate according to market forces and is not controlled by the authorities. This kind of exchange system is useful for countries that need to achieve a real depreciation to either get out of a recession or clean up a trade deficit.

In a system of fixed exchange rates, a country cannot use its exchange rate to solve its problems since the exchange rate will be at a certain level. One drawback of the fixed rate is that the country to defend the exchange rate must renounce the management of its monetary policy concerning the interest rate since with this they manage to maintain parity when they equalize the local interest rate with the interest rate. of interest of the foreigner.

In the medium term, the authorities manage to adjust the real exchange rate by modifying the nominal exchange rate or by altering the level of prices in the country to equalize the price of goods abroad. In an open economy with fixed exchange rates, the price level will affect production through the effect they produce on the real exchange rate since prices cause a rise in the actual exchange rate. This genuine appreciation causes a decrease in the demand for local goods and, in turn, a reduction in domestic production.

In short, a price increase makes domestic goods lower thus reducing their demand. In the short term, a fixed nominal exchange rate implies a fixed real exchange rate. In the medium term, the real exchange rate can be adjusted, although the nominal rate is fixed since the adjustment is achieved through changes in the price level.

In a fixed exchange rate system, the economy can produce its potential in the medium term, but the adjustment to maintain that exchange rate can be complicated for the authorities. If a government wants to boost production to its natural level with a fixed-rate system, it can devalue its currency only once to avoid losing credibility. This devaluation causes a real depreciation and therefore an increase in production. But this devaluation must be in its correct proportion because if it exceeds undesired effects may appear.

Depreciation does not immediately affect production. Initially, depreciation may have a contractionary effect since consumers will pay more for imports without having generated the adjustment between imports for exports. Besides, it will directly affect the prices of goods in general, so that the consumption basket will increase its price, and this will lead workers to request a higher nominal increase in their salaries and force companies to raise their prices respectively. It will reach the point already studied that a devaluation can boost production, but this will take due to all transmission mechanisms.

When a country has fixed exchange rates and faces a high trade deficit or a broad recession there are incentives to leave the parity and devalue the currency to have tools to activate production. So, many economists prefer flexible exchange rates than fixed because in some parities the national currency may be overvalued, and this will affect in the medium term or until parity ends economic development as it will mainly affect exports.

There is evidence that shows that the lower the interest rate, the lower the exchange rate will be. So, a country that wanted to maintain a stable exchange rate had to keep the interest rate close to the foreign interest rate. This is because many investors are continually looking at the interest rate since many investments such as bonds depend on this interest rate. So, if a country like the United States increases its rates, it will make its bonds more attractive for profitability and low risk, and this will end up affecting other nations if they do not follow that interest rate increase.

Therefore, a country that would like to achieve a depreciation would only have to lower interest rates in the correct proportion. But the relationship between fees is not that simple. In many cases, the interest rate may fall, and the exchange rate may not. In addition, the magnitude of the correlation between both rates can vary. To predict the magnitude of the correlation, expectations about future rates should be introduced, and thus the ratio of the exchange rate to increase or reduction in the interest rate could be predicted.

Any factor that alters the current or future local or foreign interest rates will affect the current exchange rate. Therefore, to predict a current exchange rate it is not enough to analyze the local market and its relationship with other variables such as raw materials, foreign economies or interest rates, it is also important to examine the expectations of the investors of the future that will be determined at present.

To finish this article, we will clarify what the decision of the countries should be when they are choosing the type of their exchange system. Exchange rate systems can be crucial in economic development in the short term. In the short term, countries that have fixed exchange rates and perfect capital mobility relinquish control of their interest rate and exchange rate. That reduces their ability to respond to shocks and can also generate currency crises where they cannot maintain their parity even selling central bank reserves and after a while, they must leave their exchange rate free.

If a country has a fixed exchange rate and investors expect a large devaluation, they will ask for higher interest to reflect that risk, which will worsen the economic situation and put more pressure on the country to devalue. One problem with flexible exchange rates is that the exchange rate can fluctuate significantly and control over this is difficult. This will generate uncertainty among the agents in the economy and may affect some transactions. But with the flexible exchange rate, countries have more tools to deal with external shocks, which is why most economists prefer this type of system.

But the system of fixed exchange is preferable when there is not full confidence in the central bank with its management of the exchange rate parity. An extreme measure to not be aware of the rate of change is the adoption of a single currency among several countries such as the euro. With the adoption of a single currency, the fluctuations of the currency with the countries that are most traded are eliminated, but this, also, has problems since autonomy is lost in the monetary policy decisions and it is exposed to all the economic problems that may arise in the common area of that currency.

Forex Educational Library

Limitations On Monetary Policy


Macroeconomics currently has different models to analyze how markets behave, which relationship has different indicators and what effect the application of certain policies could have. But the problem with the theory is that it does not consider all the variables that really affect, and a principle of the models is the simplicity and because there are variables that behave differently than would be expected. This mainly occurs with the expectations of people because it is a variable that cannot be controlled and can behave very differently than would be expected.

In the last century, various models have been developed to explain economic behavior, but it is still far from perfection. When central banks see an increase in unemployment, they try to give a stimulus to the economy with the help of the interest rate or with an increase in the amount of money. But when those incentives are considered, the banks use macroeconomic models to see the possible effects of their measures, although there is no perfect model to indicate the real effects. The problem is that in the diversity of models that exist each one shows different magnitudes in the effects of the interventions so that the banks do not know with certainty what can happen in the economy.

Given this uncertainty about the effects of economic policy, some analysts believe that central banks should not intervene so much in the economy to avoid possible unwanted effects. In general terms, central banks should limit themselves to avoiding prolonged recessions, curbing dangerous expansions, and avoiding inflationary pressures. The higher the unemployment or the inflation the measures of the bank should be stronger but neither aspires to a perfect effect since this does not exist.

One of the main reasons why the effects of monetary policy are uncertain is a topic discussed in the article Expectations in the economy. Expectations and their interaction with central bank policies distort the effects of policies, because not only the variables of the present matter but the expectations of the future as well. For a central bank policy to be efficient and have the desired effects their policies must be credible by the agents of the economy to change the expectations of these.

But another problem facing monetary policy apart from the expectations of consumers, investors and other players, is the political interests of the authorities of the countries. Politicians do not always do the best for the economy as they always avoid making difficult decisions and always do what they are represented by votes. Another problem is the alternation in the power of different ideologies that do not allow economic and monetary policies to be lasting over time. All the above is to highlight the limitations of monetary authorities and because despite the development of economic theory it has not been possible to perfect predictions about the effects of monetary policy.

One of the issues that banks should deal with is inflation. Inflation has four costs recognized by economists:

  • An increase in inflation leads to an increase in the nominal interest rate and therefore the cost of opportunity to have money so that people prefer money in the bank and this leads to having to go more often to the bank.
  • Inflation generates fiscal distortions. For example, when a company must pay capital and income taxes if there is a high inflation rate it may end up paying more because of this effect.
  • Inflation variability generates that year after year no one knows exactly what the inflation rate will be affecting certain assets such as bonds.
  • Inflation causes an effect called monetary illusion that causes people to make systematic mistakes because they value different real and nominal purchasing power changes.

But inflation also has positive aspects. The creation of money by banks and which is the cause of inflation is a way in which the state can finance its spending, for example, it is an alternative to borrowing from the public or raise taxes. It is also positive because when an economy is in a recession the central bank can take expansionary measures and thus help the economy. But if the economy has 0 inflation, or it is very low, monetary policy will be hard to implement and therefore it will be difficult to return production to its natural levels by the bank. In many countries, the main objective of central banks is to achieve an inflation rate between a pre-determined range for each bank that is supposed to be good for the economy. In the following graph, you can see the inflation rate of different countries including Venezuela that is having serious problems in its economy.

Inflation, consumer prices

Graph 9. Inflation, consumer prices. Data taken from the World Bank.

Another way aside from the interest rate to control production fluctuations is the fiscal deficit. It is true that the fiscal deficit helps in the negative cycles, but it must also be considered that fiscal deficits have a negative impact on capital accumulation in the long term. For the debt not to advance continuously when there are expansions in the economy it should be intended to have fiscal surpluses to clean up national accounts. Due to the problems generated by an increase in the debt generated by the fiscal deficit, it is important that investors and citizens are monitoring the fiscal deficit of countries as this can end up affecting the growth in the medium and long-term.

As mentioned before the policy plays an important role in the monetary decisions and the course of the economies so that the healthiest thing for the countries would be to limit their interference in the decisions of the Central Bank and other policies aimed at limiting the fiscal deficits because to not lose support a government may be able to borrow beyond what is necessary and healthy by affecting long-term growth where those governments will no longer be.

European Union.

The next part of the article will be based on the monetary integration of Europe and the details of this integration. The decision to adopt a single currency such as the Euro is the most extreme way to set the exchange rate between countries in a region. When the central bank worries about the exchange rate and tries to fix a stable exchange rate there are many problems for the parity to remain so by unifying several countries under a currency these problems are eliminated as losses of reserves, but other problems arise. In the next graphic shows the members current of the European Union.

Top 30 maps and charts that explain the European Union

Graph 10. Buczkowski A. (2017, March 27). Top 30 maps and charts that explain the European Union. Retrieved October 16, 2017, from

The European countries managed to establish a single currency because throughout history they had had some concerns that led them to take this measure. The first factor is the openness of European economies since they are so exposed to trade, so they are also more exposed to fluctuations in the exchange rate than other countries in the world. The greater proportion of exports or imports in national income the economy is more sensitive to changes in the exchange rate. Secondly, Europe has historically great fluctuations that have led to economic crises and conflicts between them. And the last factor determining the monetary union in Europe was the common agricultural market. This market for its operation needed a stable exchange rate so that helped in the decision to unify the currency.

Then introducing the causes of Europe’s monetary union will now discuss how monetary policy is managed. Europe’s monetary policy is managed by the European Central Bank which, together with the central banks of all the Member States of the European Union, constitutes the European system of central banks. This system is independent of other institutions such as national governments. Monetary policy decisions are centralized in the European Central Bank so that European monetary policy is unique, but its application is decentralized in the national central banks who are responsible for carrying out operations of an open market in their countries.

The governing bodies of the European Central Bank are the Governing Council and the Executive Committee. The Governing Council is composed of the six members of the executive committee and the governors of the national central banks of the countries that are part of the eurozone. This body is responsible for monetary policy and sets out the guidelines for its implementation. The council normally meets twice a month on Thursdays. The executive committee implements monetary policy and gives instructions to the national central banks. The governing bodies of the European Central Bank agree on the policy to be implemented by voting and win the decision that has the most votes. The governors of the national central banks have the same weight in the votes regardless of the economic importance of each country.

The basic task of the European Central Bank is to manage the monetary policy of the European Union and the main priority of this policy is the stability of prices. The bank has established that price stability is defined as an inter-annual increase in euro-zone price indices of less than 2% but positive. Due to this, the central bank decides its corrective measures based on the deviations of the expected inflation with respect to the desired path. To achieve the price target, the central bank has two strategies, the first is related to the money supply and consists of announcing the benchmark for the growth of money. The second strategy consists of an economic analysis of different economic indicators such as economic activity, labor costs, financial assets among others and with this analysis are fixed the interest rates.

A major problem facing the central bank when making decisions is the economic fluctuations of each member country of the European Union. The asymmetric economic cycles have their origin in different specializations of each country and that causes asymmetric perturbations since the most developed sectors in each country face different offers and demands. There is evidence that, with the European Union, many regions have reduced the possibility of being affected by asymmetric shocks thanks to economic integration, but this effect has not been seen in all countries.

An important factor that reduced the costs of monetary union is the existence of interregional labor mobility, since if the demand for a product in one country is reduced and the labor force in another increase the labor force can move freely to the country where it has this more developed sector. But despite good labor mobility, some economists argue that Europe is not an optimal monetary union since country governors vote for measures favorable to their respective countries or otherwise the measures end up affecting more a country that is in a recession than a country that is well economically.