In the IS-LM framework, when the CB expands Money supply, interest rates are driven down, investment is boosted, and aggregate output increases (shift of LM curve, movement along IS curve). In the case of the Eurozone, given that member countries are not able to unilaterally expand money supply- this is the mandate of the ECB- it is often said that there is no monetary independence. However, interest rates in different European countries are different. I have two questions:

i) Even though the currency is the same, the interest rates are different. Would a risk premium be the only explanation for the interest parity condition not holding here (there is no risk of devaluation for the same currency)?

2) The Central bank of each country has no power over the money supply. However, the yields are still different. Is this purely a result of market forces (again determined by differences in risk?)?

In a broader sense, what is the role of the European network of central banks when they can't control the Money supply ? (the main purpose of existing for most central banks).


1 Answer 1

  1. It’s the same currency and interest rate structure for all countries. The only difference is that there is a default premium for some countries. You see the exact same thing in Canada, with the Canadian provinces trading at different yields.
  2. The ECB is literally the union of all the national central banks. When the ECB makes a decision, it is implemented at the national central bank level.

The IS/LM model has severe limitations. The ECB sets interest rates; it’s ability to control “the money supply” (which aggregate?) is debatable. (It can increase the size of the monetary base, but that does not imply that bank deposits etc. will grow.)

  • $\begingroup$ Thanks! So when the ECB decides to increase liquidity for country x, does it buy bonds of this country? $\endgroup$
    – ChinG
    Commented Dec 2, 2018 at 0:48
  • 1
    $\begingroup$ I have not kept up with latest developments, but I believe that it would normally set overall targets, and then have limits for each country. With the rise of default risk worries, they had to support various countries, and so the mix of bonds they bought was a sensitive issue. Pre-2008, this was not a big concern. $\endgroup$ Commented Dec 2, 2018 at 0:54

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