Posted: July 25th, 2022

The Impact of ECB Interest Rate Cuts

The European Central Bank (ECB) sets monetary policy for the entire Eurozone (an area comprised of 18 countries in Europe). It also issues the “euro”, the common currency for the Eurozone. The ECB has to decide whether it will lower interest rates over the next year to the lowest point on record. In a world of mobile capital, the ECB’s interest rate policy is coming under increasing scrutiny, both at home and abroad. Some economic sectors within the Eurozone economy are concerned about the effect that a rate drop could have on the euro’s exchange rate. However, other sectors are excited about the potential exchange rate effects. Outside of the Eurozone, many countries are worried about how the Eurozone rate change would affect the flow of capital in and out of their own economies.
-You are the top economic advisor to the ECB. The body has requested that you write a 750-1000 word memo answering the following questions which will influence its vote on monetary policy:
Question: Taking into account global capital flows, what kind of impact will an ECB interest rate cut (decrease) have on the Eurozone economy? What kind of impact will it have on foreign economies?

Try to break the essay into parts with these questions in mind:
-If the ECB cuts interest rates, what impact will this have on capital flows?
-How will those capital flows affect things like exchange rate movements?
-How will those exchange rate movements impact the EU economy and foreign economies?
Student’s Name
Professor’s Name
Course Number
Due Date
Memo:
The Impact of ECB Interest Rate Cuts
For over a decade now, the ECB has played a significant role in lowering the interest rates to ensure inflation remains at the 2% level. Generally, the ECB has three fundamental interest rates which could be lowered, precisely the primary refinancing rate, the deposit rate, and the marginal lending rate. All these rates have been cut as part of ECB’s measures to ensure price stability over the medium term. This is a necessary condition for the euro area to attain sustainable growth. Notably, the consistent lowering of the interest rates even to negatives has remained controversial. The primary aim of this statement is to illustrate the effect of ECB interest rate cuts on both the Eurozone economy and the foreign economies. The primary focus will be their effect on capital flows. Consequently, the discussion will highlight how the impact on capital flows affects elements such as the exchange rate movements and subsequently how the latter will affect the EU and foreign economies.
Generally, a change in interest policy rates will affect the marginal costs of banks as they obtain external finance differently since it depends on the level of individual resources or the bank capital. The interest rate channel has mainly been relevant during crisis periods such as a financial crisis where there is scarce capital, and banks find it challenging to raise capital (Den Europæiske Central bank). It is, however, prudent to note that this recapitalization has a contractionary or accommodative impact on bank lending, which relies on how the strategy has affected the bank’s profitability. Typically, when the interest rates are too low, the net interest income to lift the banks is depressed (Brunnermeier and Yann 28). The banks’ net worth decreases, and they will be forced to increase the rates of awarded loans to reduce their leverage expenses. Ultimately the monetary policy stimulus of reduced interest rates becomes contractionary to the economy of the Euro area.
It is important to note a high correlation between interest rates, inflation, and exchange rates. The manipulation of interest rates by the Central bank will affect both inflation and exchange rates, while a change to interest rates affects inflation and currency values (Twin). Lower interest rates offer the lenders within the economy lower returns concerning other countries. To this effect, the lower interest rates will reduce the foreign capital and cause a reduction in the exchange rate. However, the effect of interest rates will be altered when the region’s inflation is much lesser than that of the other countries (Twin). The opposite relationship is also prevalent. An increase in the interest rates will increase the exchange rates due to an attraction of foreign capital seeking higher returns.
Therefore, with the expectation of exchange rates being affected by changes to interest rates, then with interest rate cuts being imposed by the ECB that go beyond zero/ or become negative, reactions are expected similar to the reactions when the rates are positive. It is also possible that the sensitivity of an exchange rate to interest rate differentials goes up when the rates are cut (Brandao-Marques 12). When the ECB adopts an interest rate cut to a point, it becomes harmful. The impact is on both the expected policy rates’ level and distribution over the medium term. Another reason is the preferred habitat effects that cause the exchange rates to behave differently when the low-interest rates are adopted. For instance, if the cross-border flows via mutual funds and other institutional investors are sensitive to the interest rate differentials when the rates are positive, they will be affected when the interest rates are low to the negative extent (Brandao-Marques 12). Researchers have indicated that there is existing proof to show that the low-interest rates make the exchange rates for the major currencies more sensitive to the changes in monetary policy expectation.
In understanding the impact of the low-interest rates in the Eurozone and the foreign economies, different economic factors must be assessed through the net interest income. According to Holzhausen and Romero, the findings from the assessment have shown that the benefits from the low-interest rates are not equally distributed, nor does it heed to the North-South divide. The primary beneficiaries have been Spain, Portugal, Netherlands, Italy, and Germany. Conversely, countries such as Finland, Belgium, and France have been on the losing side. Additionally, some governments did not get to benefit from the low-interest rates because the countries are dealing with an increase in their debt levels which is eating up their savings from the lower interest rates, considering Germany did improve its negative net interest income substantially by 6% of its GDP since a debt restraint accompanied the low-interest rates. The third factor has very heterogeneous private households, and changes in their behaviors drive these households. Therefore, it is essential to understand that these low-interest rates affect the economies of the countries in the Eurozone differently, causing shifts in the entire Eurozone economy.
Notably, it is essential to note that keeping the interest rates low only leads to an annual tax on the savers, with benefits being transferred from the lenders to borrowers. This monetary policy instrument may have worked immediately after the 2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers financial crisis, the effect of the foregone interest income on the private sector is considerable (Krecke). Research has proven that financial repression will encompass high expenses, especially for long-term investments. This lowers the investors’ capacity to put money or capital back into the real economy to support growth. Similarly, the volatility and risk growing within their financial markets have forced governments to accumulate massive dents. Some EU countries are now more indebted compared to their debt status before the 2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers crisis. Over 15 EU member countries have debts higher than 60% of their GDP, while eight countries illustrate debt levels over 100% of their annual output (Krecke). The downsides of these low-interest rates and the larger expansionary monetary policy are evident through the slow economic growth these countries can sustain.
As previously noted, the low-interest rates lead to a lower exchange rate which incentivizes both businesses and households to substitute away from the country’s imports towards their domestic products (Guttmann et al.). This also increases the compa=etiviness of the EU countries’ exports hence reducing the import volumes as export volumes increase. Growth in the net export accounts will positively affect the domestic economies while the foreign economies depend on the EU market is adversely affected. There is a tradeoff from having low-interest rates, which includes the region benefitting considerably from more exports.
Ultimately, primary stakeholders must do a comprehensive policy analysis on how low-interest rates should be implemented to benefit the Eurozone economies fully.

Works Cited:
Brandao-Marques, Luis, Gunes Kamber, and Roland Meeks. “Negative interest rates: taking stock of the experience so far.” Departmental Papers 2021.003 (2021).
Brunnermeier, Markus K., and Yann Koby. The reversal interest rate. No. w25406. National Bureau of Economic Research, 2018: 2024 – Write My Essay For Me | Essay Writing Service For Your Papers Online.
Den Europæiske Central bank. “Transmission Mechanism.” European Central Bank, 2021, www.ecb.europa.eu/mopo/intro/transmission/html/index.da.html.
Guttmann, Rochelle, Dana Lawson, and Peter Rickards. “The economic effects of low interest rates and unconventional monetary policy.” 1. 1 Managing the Risks of Holding Self-securitisations as Collateral 2. 11 Government Bond Market Functioning and COVID-19 3. The Economic Effects of Low Interest Rates and Unconventional 21 Monetary Policy 4. Retail Central Bank Digital Currency: Design Considerations, Rationales (2020): 21.
Holzhausen, Arne, and Romero.Patricia P. “Europe’s Low Interest Rates Have an Impact but Not the Way You Think.” Euler Hermes | Global Trade Credit Insurance Leader, www.eulerhermes.com/en_global/news-insights/economic-insights/Europe-s-low-interest-rates-have-an-impact-but-not-the-way-you-think.html.
Krecke, Elisabeth. “Europe Will Find It Difficult and Dangerous to Escape the Trap of Ultra-low Interest Rates.” Geopolitical Intelligence Services, 2018: 2024 – Write My Essay For Me | Essay Writing Service For Your Papers Online, www.gisreportsonline.com/the-consequences-of-prolonged-low-interest-rates-in-europe,economy,2465.html.
Twin, Alexandra. “6 Factors That Influence Exchange Rates.” Investopedia, 2021, www.investopedia.com/trading/factors-influence-exchange-rates/.

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