ABSTRACT
Introduction The twenty-first century witnessed the rise of the European Monetary Union (EMU) and European Central Bank (ECB), shaping the conduct of monetary policy for nineteen countries currently forming the euro area with a common euro currency. This monetary union was not coupled with a fiscal union, making the ECB operate in an environment in which it faces many fiscal authorities instead of one, which was the traditional form of monetary policy until the year 2000. This monetary union operates in a euro area that is sometimes divided into a two-tier system characterized by widely divergent unemployment and growth rates. Inflation rates are calculated based on a harmonized index of consumer prices (HICP) aiming at an average for the nineteen countries below but close to 2 percent to achieve the price stability objective as per the Maastricht Treaty. The differences in the macroeconomic indicators cause the common monetary arrangements to be loose for some countries and tight for others, making policy interest rates relatively too low for one group and too high for the other. Differences in economic fundamentals sometimes cause the euro to be overvalued for one group and undervalued for the other, impacting trade activities within the euro area and with the rest of the world. Additionally, the lack of a fiscal union or some type of disciplined fiscal integration has been perceived by many as leaving member countries with fiscal imbalances prone to inflows of shocks and crisis, causing declines in aggregate demand and contagious systemic dangers across the eurozone. These salient features require appropriate monetary policy arrangements, and these are different than the ones practiced by central banks facing one fiscal authority, given that the aim is to achieve the price stability objective and a macroeconomic environment characterized by high output and employment growth across various members. On another hand, the twenty-first century also witnessed a major financial crisis that has reshaped the international financial architecture. This crisis caused many central banks across the world to hold additional reserves for both precautionary reasons, reflected in responses to various market shocks and prevention of disorderly market conditions, and non-precautionary reasons, to protect fixed pegged exchange rate arrangements and provide international liquid assets. This reserve accumulation is believed to have a social cost when inappropriate amounts of
reserves are accumulated. Thus, a literature is developing dealing with reserve adequacy or the determination of the optimal amount of reserves to be held by central banks.
