is set at 100 basis points above the target financing rate. The marginal lending rate
provides a ceiling for the overnight market interest rate in the European Monetary
Union, just as the discount rate does in the United States. Just as the Fed does, the
Eurosystem has another standing facility, the deposit facility, in which banks are paid
a fixed interest rate that is 100 basis points below the target financing rate. The
Like the Federal Reserve, the European Central Bank imposes reserve requirements
such that all deposit-taking institutions are required to hold 2% of the total amount
central banks. All institutions that are subject to minimum reserve requirements have
access to the European Central Bank’s standing lending facilities and participate in
open market operations. Unlike the Federal Reserve, the European Central Bank pays
interest on reserves. Consequently, the banks’ cost of complying with reserve require-
ments is low.
232
Part 4 Central Banking and the Conduct of Monetary Policy
The Price Stability Goal and the Nominal Anchor
Over the past few decades, policy makers throughout the world have become increas-
ingly aware of the social and economic costs of inflation and more concerned with
maintaining a stable price level as a goal of economic policy. Indeed, price stability,
which central bankers define as low and stable inflation, is increasingly viewed as the
most important goal of monetary policy. Price stability is desirable because a rising
price level (inflation) creates uncertainty in the economy, and that uncertainty might
hamper economic growth. For example, when the overall level of prices is chang-
ing, the information conveyed by the prices of goods and services is harder to inter-
pret, which complicates decision making for consumers, businesses, and government,
thereby leading to a less efficient financial system.
Not only do public opinion surveys indicate that the public is hostile to infla-
tion, but a growing body of evidence also suggests that inflation leads to lower eco-
nomic growth.
7
The most extreme example of unstable prices is hyperinflation, such
as Argentina, Brazil, and Russia have experienced in the recent past. Hyperinflation
has proved to be very damaging to the workings of the economy.
Inflation also makes it difficult to plan for the future. For example, it is more
difficult to decide how much to put aside to provide for a child’s college education
in an inflationary environment. Furthermore, inflation can strain a country’s social
fabric: Conflict might result, because each group in the society may compete with
other groups to make sure that its income keeps up with the rising level of prices.
The Role of a Nominal Anchor
Because price stability is so crucial to the long-run health of an economy, a central
element in successful monetary policy is the use of a nominal anchor, a nominal
variable such as the inflation rate or the money supply, which ties down the price
level to achieve price stability. Adherence to a nominal anchor that keeps the nom-
inal variable within a narrow range promotes price stability by directly promoting low
and stable inflation expectations. A more subtle reason for a nominal anchor’s impor-
tance is that it can limit the time-inconsistency problem, in which monetary pol-
icy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes.
8
The Time-Inconsistency Problem
The time-inconsistency problem is something we deal with continually in everyday
life. We often have a plan that we know will produce a good outcome in the long run,
but when tomorrow comes, we just can’t help ourselves and we renege on our plan
because doing so has short-run gains. For example, we make a New Year’s resolu-
tion to go on a diet, but soon thereafter we can’t resist having one more bite of that
rocky road ice cream—and then another bite, and then another bite—and the weight
begins to pile back on. In other words, we find ourselves unable to consistently
7
For example, see Stanley Fischer, “The Role of Macroeconomic Factors in Growth,” Journal of
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