The European Central Bank

The Federal Reserve System works as the central bank of the United States and controls the monetary policy in the U.S. But do other countries have a similar system? How does it work precisely in Europe?

In this article, we will learn all about the European Central Bank, its importance for monetary policy, and its operations. Ready to learn? Start reading!

European Central Bank Overview

Let's start with a European Central Bank overview. The European Central Bank (ECB) works as the central bank in Europe for the member countries of the eurozone; those countries that have adopted the euro as their national currency. There are currently 19 countries in the eurozone.¹

The European Central Bank is headquartered in Frankfurt, Germany. The main responsibility of the European Central Bank is to manage monetary policy and maintain price stability in the eurozone.

Importance of the European Central Bank

To understand the importance of the European Central Bank, we first need to understand how it developed over time. The European Central Bank was created in 1999 by 11 European countries¹ who decided to adopt the euro as their national currency and agree to allow the European Central Bank to manage their monetary policy. After 1999, other European countries joined the eurozone, and the importance of the European Central Bank grew. Today it is one of the main monetary organizations in the world.

Although the United States still has the world's largest economy, the economy that the European Central Bank controls is roughly as big as the U.S. economy. Therefore, the monetary power the European Central Bank holds is comparable with the Federal Reserve System (FED) in the U.S.

The responsibilities of the ECB are very curial for the financial markets as well as the welfare of society. Since the economy controlled by the ECB accounts for a significant share of the world economy, it also has an enormous impact on the world economy.

Fig 1. - European central bank building

Functions of the European Central Bank

The functions of the European Central Bank are very crucial for the economy. Similar to the FED, the legal status of the ECB is not quite simple: it is not exactly a governmental institution, nor is it a private bank.

In fact, the counterpart of the FED in Europe is not the ECB but the local national central banks such as the Bank of Italy, Bank of France, etc. These national banks were the exact equivalent of the FED in Europe until 1999 since they used to control monetary policy in their country, just like FED controls monetary policy in the U.S.

These national banks are of course still active and responsible for the regulation of various financial services to local banks and institutions and manage the open-market financial operations in their countries. However, the national central banks in Europe do not control their own monetary policy anymore. Since they all use the euro now, only the ECB has the responsibility to regulate monetary policy in the eurozone.

The main decision-making body of the ECB is the Governing Council. The Governing Council of the ECB has six members² of the Executive Board and the governors of the national central banks of the 19 countries in the eurozone. The Executive Board is appointed by the European Council.²

The ECB decides and manages monetary policy for the eurozone. The ECB has the following responsibilities:

• decide the targeted inflation rate, as well as the way inflation is measured
• control the supply of euros available in the financial markets by controlling the amount of euros available to eligible member banks
• manage the interest rate through the supply of available euros in the market
• establish and adopt necessary guidelines to support the economic activity level in the eurozone
• manage exchange operations related to foreign financial markets
• banking supervision through the adoption of decisions proposed by the Supervisory Board

European Central Bank Monetary Policy

European Central Bank monetary policy has significant importance in the European economy. The primary mandate of the European Central Bank is to maintain price stability in the eurozone.

The European Central Bank can decide the inflation target as well as the way inflation is measured.

In the past years, the annual inflation rate target has been 'maintaining 2% inflation over the medium term.'

Since the inflation target is symmetrical, inflation rates that are too low are also perceived negatively. The aim behind this is to protect the financial system from the risk of destabilizing deflation during a recession.

Even though price stability is the main mandate of the ECB, it has some secondary mandates with no prejudice to the mandate of price stability. Those secondary mandates include targets for full employment and environmental protection.

Operations of the European Central Bank

What are the operations of the European Central Bank? To maintain price stability in the eurozone and to keep inflation at the desired level, there are several economic instruments that the ECB controls or operates. The control of the interest rate is one of the main operations of the European Central Bank used to control the inflation level.

Another important operation of the European Central Bank is managing the supply of the euro. If prices increase for some reason - such as a sudden increase in demand or an unexpected decrease in supply - the ECB normally decreases the amount of available euros in the financial markets to balance the market. If the economy falls into a recession, meaning a decline in economic activity, the ECB would increase the amount of available euros in the market to bring the economic activity level back to its previous level.