In this chapter we examine the evolution of the ECB's monetary policy and its theoretical approach in the first phase of EMU. First we set out the character and role of money in the Keynesian paradigm. Then we turn to the two-pillar strategy of the ECB, which combined neoclassical and Keynesian elements of monetary policy. Finally, we examine the Wicksellian approach to money and monetary policy, which became dominant after the failure of the two-pillar strategy.

Money in the Keynesian tradition

Money in a monetary production economy (Keynes 1933) plays a central role for stability and dynamics of capitalist systems. Money has three basic functions: as a unit of account, as a means of payment, and as a store of wealth.

Money as a unit of account is the most basic function of money and cannot be substituted without changing the monetary system. An example is the change from the D-Mark to the euro in 1999. Money as a unit of account is needed to express the value of goods and for calculations in balance sheets, etc. More importantly, money is a unit of account in credit contracts. In this function it becomes highly desirable that the unit of account measured in real purchasing power is stable, which requires a relatively stable and low inflation rate. In a situation of high inflation rates creditors can at least theoretically defend a given real interest rate (nominal interest rate minus inflation rate) when the nominal interest rate is adjusted to the inflation rate. But uncertainty in such a situation and the danger of the further erosion of the monetary system is high. During deflation the real debt burden increases (Fisher 1933).

Money as means of payment is transferred from one economic agent to another to buy goods, to pay out or pay back credits, and to fulfil all kinds of obligations, such as taxes. This function of money implies that money has to be kept as a store of wealth.

There are several motivations to keep money. First, money is kept to carry out daily transactions. Second, if the cash flows of private households or firms are irregular, money is kept for precautionary purposes. Third, speculators may see advantages to keep cash. Finally and most importantly, money is held as the embodiment of wealth as such.