SJAS 2014, 11 (1): 16-24

ISSN 2217-8090
UDK: 338.23:336.74(4-672EU)
DOI: 10.5937/sjas11-4902
Original paper/Originalni naučni rad

MONETARY AND FOREIGN CURRENCY POLICY

Vladimir Mladenović1,*, Мiroljub Hadžić2

Abstract:
The paper analyzes how successful the ECB has been in pursuing its mon-
etary and foreign exchange policy, which is, at the same time, a complex
issue and crucial for the justification of its existence. Firstly, the ECB is
trying hard to keep up with the global crisis and to maintain the stability
of the euro. The main task of the ECB is to keep inflation below 2% p.a.
This paper demonstrates that the ECB has managed to retain inflation Key words:
within the required limits for a significant period of time, except for few monetary policy,
relatively short-lived exceptions. By managing an adequate monetary European Central Bank,
policy the ECB has successfully accomplished its goals in the period of inflation,
reference, as demonstrated by inflation trend results, monetary aggregate interest rates,
M3, and the level of interest rates. euro.

EUROPEAN CENTRAL BANK AND ITS tion of present positions within the ESCB and the
INDEPENDENCE efficiency of such a monetary policy management.
In the past, central banks were seen as institu-
tions capable and responsible to fulfill several goals
The European Central Bank was established on
at the same time: providing the high rate of econom-
June 1, 1998. Along with national central banks of
ic growth and employment, financing state budget
17 members of the European Monetary Union (Eu-
and coping with balance of payment problems. In
rozone) and central banks of other EU members, it
line with this, economic theory did not comment on
constituted the ESCB (European System of Central
the independence of central banks and credibility of
Banks). The main task of the ECB was to manage their monetary policies. Today, the independence of
operations related to the introduction of a common central banks is higher than before and their primary
currency – the euro, and to supervise the whole pro- goal is price stability (Cukierman, 2007, p. 368). The
cess. According to the Maastricht Agreement, the Independence of a central bank is understood as the
ESCB is the cornerstone of monetary power of EU, existence of high level of freedom in the creation and
which defines monetary aggregates, monetary pol- realization of monetary policy. However, the inde-
icy and implements monetary instruments. Some pendence of central bank is a rather wider concept:
authors argued (Bernholz, 1999, p. 777) that the personal independence, financial independence and
decision to leave national central banks within the independence in monetary policy (independence in
ESCB could be linked to some aspects of the mon- formulation of the goal and independence in mone-
etary policy management and the decentralization tary instruments introduction) (Barjaktarović, 2010,
issue on one hand and, on the other hand, the reten- p. 167).
16 * E-mail: [email protected]
 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

According to the Maastricht Convention, the volves an active participation of the banking system
ECB is in charge of maintaining stable prices, as in the regulation of credit volume and its structure
well as preserving the stability of output and em- in economy. Active influence on one of the main
ployment rates. In order to achieve these goals, the channels of the creation and withdrawal of money
ECB built up a wall to protect itself from the inter- in circulation, as well as on credit volume involves
ference of politics (Grauwe, 2005, p. 176). The in- detailed and carefully crafted actions through which
dependence of the ECB is closely related to its main a predominant portion of money in economy is de-
goal – price stability. The concept of independence termined. Therefore, the two concepts merge into
of the ECB consists of: institutional independence, one, namely the monetary-credit policy, since op-
legal independence, functional and operational in- erations are not exclusively “monetary“ or “credit“,
dependence, financial and organizational independ- although there is a commonly held view that the cur-
ence (Scheller, 2006, p. 124). rent money is basically credit(deposit) money (Barać
The ECB only recognizes the aim of the mon- et al., 2007, p. 58).
etary policy. This is laid down by the Maastricht Central banks usually use three main monetary
Convention which, at the same time, empowers instruments:
the ECB to pursue other goals, provided that they ◆ Open market operations – supply or with-
do not undermine price stability (Grauwe, 2005, p. drawal of state securities;
207). Price stability can be understood as the situa- ◆ Rate of refinancing – interest rate by which
tion with neither inflation nor deflation in the long central banks are ready to finance commer-
run (Gerdesmeier, 2011, p. 24). Price stability was cial banks, within national economy, in the
firstly defined in 1998 by Supervisory board of the short run;
ECB as annual HICP (Harmonized Index of Con-
sumer Prices) bellow 2%, in medium period. It was ◆ Compulsory reserves – part of deposits col-
slightly changed in 2003 into: annual inflation rate lected within commercial banks, which has
under, but near to 2%, in medium term (European to be unused for credit lending (Mankiw and
Central Bank, 2011, p. 65). Taylor, 2011, p. 600).
Strategy of ECB monetary policy is based on:
◆ Quantitative definition of the price stability
MONETARY POLICY (inflation rate below, but near to 2% annually,
in the medium run) and
The monetary policy and policy of public financ- ◆ Two anchor approach for the examination of
es are the most important components of macroeco- price stability risk:
nomic policy. Monetary policy’s function is to regu- ◆ Firstly, economic analysis of factors which de-
late the amount of money in circulation, maintain termine prices in short and medium run and
the balance between commodity stocks and mone-
◆ Secondly, monetary analysis of the relation
tary funds, enable smooth performance of commod-
between money supply and prices in long run
ity circulation, and ensure a stable economic course.
(Gerdesmeier, 2011, p. 63).
Monetary-credit policy relies on certain catego-
ries – monetary indicators, which are used in the
definition of the quality and the function of money FOREIGN CURRENCY POLICY
in economy, as well as in management of the mon-
etary policy and the solvency policy in economy and The system of economic relations with foreign
other sectors. These indicators actually constitute the markets, as an important part of the economic sys-
basis for an efficient monetary policy, since they are tem, should provide conditions for a rational inte-
used as the means for controlling its effects, in the gration of the national economy into the interna-
first place its basic orientation and its adjustment to tional division of labor. This primarily means that
current economic trends. They are called monetary systemic instruments will provide an objective as-
aggregates (Barać et al., 2007, p. 59). sessment of cost-effective engagement of produc-
Monetary policy involves the mastering and con- tion factors in individual economic activities and,
scious directing (i.e. control) of all forms and flows consequently, the identification of sectors in which
of money in reproduction (solvent, insolvent, for- a national economy makes the most of available re-
eign currency, and other funds). Credit policy in- sources (Jovanović Gavrilović, 2008, pp. 23-24).
17
 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

The price at which one national currency is to such a development, some international insti-
exchanged for another is called foreign currency tutions were forced to ask for an additional sup-
rate. Foreign currency rate should be distinguished port from the governments. However, bankruptcy
from foreign currency parity which represents an was inevitable for some international financial in-
officially established value of the national money, stitutions. Initially, commercial banks in the Eu-
expressed through a more widely accepted de- rozone faced the financial crisis from a generally
nominator, such as: gold, special drawing rights stable financial position (which at the time did not
(SDR), a more stable and important national cur- cause any concern), owing to several years of posi-
rency, etc. Under normal circumstances foreign tive (profitable) operations. Although some large
currency rate is close to foreign currency parity as banks were affected by depreciation that continued
it constitutes its basis (Jovanović Gavrilović, 2008, persistently for a year, they seemed to be resistant
pp. 23-24). to unfavorable developments until the dramatic
downturn in September 2008.
EUROPEAN CENTRAL BANK AND THE GLOBAL In 2009, the ECB Council adopted supplementa-
ECONOMIC CRISIS ry non-standard measures, as it was facing dysfunc-
tional money markets, despite relatively low ECB’s
key interest rates and low interest rates on loans.
The global economic crisis, and the crisis of in- It was also expected that support for the recovery
ternational financial markets, that occurred in the would be given through the lowering of interest rates
second half of 2007, raised numerous questions
for households and businesses. These actions sur-
about the financial stability of the Eurozone. Despite
passed the outcome which could have been achieved
the crisis, the financial system of the Eurozone re-
through the reduction of the ECB key interest rates.
mained relatively robust and resistant in 2007. Prior
This approach took into account the fact that, in the
to the market crisis the financial system of the Euro-
Eurozone, banks play the major role in providing
zone had been in a good financial position, owing to
financial resources for the real economy. As a result,
strong profitability of the banking sector that lasted
the terms of financing improved substantially, and
for a few years. Thus, the banking system was quite
this reduced tensions on the money market. All the
secure from risks. Enhanced profitability of large
non-standard actions, adopted by the Council, were
banks of the euro area in 2007 was largely driven by
temporary and designed to maintain price stability
a strong increase in non-interest income. Besides,
for the time being, in a direct and an indirect way,
the degree of profitability was also related to a (low)
while inflation expectations remained firmly an-
degree of collection of bad debts.
chored, owing to price stability.
In the course of 2008, tensions and problems
Monetary policy, implemented in 2010, led to
in the financial system of the Eurozone occurred,
and gradually only deteriorated. As months went the start of recovery of the euro area while, on the
by, commercial banks of the euro were experienc- other hand, tensions on financial markets lingered.
ing a decline in market capitalization, due to a fall The Recovery of the real economy in 2010 appeared
in share price, a decrease in the loans volume, and to be stronger than expected. Still, heightened finan-
an increase in credit expenses. As the uncertain- cial tensions recurred in May. These events could
ty, caused by global economic developments, was be treated as a result of growing concern over the
mounting, aversion to risks, felt by the participants monetary sphere, given the (un)sustainability of the
in the financial market, was growing. Credit market public finance policy (especially in Greece), since
solvency deteriorated and the availability of funds it produces adverse effects on other countries and
fell during the year, while the activity of insurance economies, particularly on the government bonds
markets slowed down. In such an environment, market.
investors and creditors started to lose confidence In 2011, the European Central Bank continued
into the ability of some financial companies to meet to be a firm and reliable support, as confirmed by
their obligations. Consequently, a lot of major fi- the fact that the expected mid- to long-term inflation
nancial companies encountered challenges, trying was stable and close to 2% but still below this level.
to access funds and capital markets. Some of the In 2011, a general rise in prices directly stemmed
largest financial institutions experienced a decline from higher prices of energy and assets, resulting in
in the price of their shares at the stock market. Due an immediate inflation rise.
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 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

The set of measures, announced and adopted by policy for the period 2004-2012 have been analysed
the ECB Council and high representatives of mem- so as to reach valid conclusions with regard to the
ber states of the Eurozone, referred to several key ECB economic policy measures.
areas, their aim having been to restore the financial
stability of the euro. Key elements of the new set of
Monetary aggregate М3
measures refer to new fiscal measures and more ef-
fective tools for stabilizing the Eurozone, including
the more efficient financial stability, faster imple- The total solvency assets (М3) is a wider ag-
mentation of the Stabilization Program mechanism, gregate than М2 and it consists of: solvency assets
and measures for tackling problems in Greece. In (М2), reserve assets, assets for the payment of or-
Greece, Ireland, and Portugal tensions on the gov- ders from abroad, assets for covering the letters of
ernment bonds market diminished but in the mean- credit, other limited deposits, assets for the purchase
time spread to Italy and Spain and, subsequently, to of foreign currency, and joint assets.
other countries of the euro area. Such developments Monetary dynamics (currency in circulation),
were also reflected in other issues, such as financial within the European monetary union, in 2004, was
sustainability in certain countries of the Eurozone, under the influence of two opposed forces: on one
concerns about global economic prospects, insecu- hand, there were low interest rates and, on the other
rity as to the financial support extended by the EU hand, the normalization of the contraction of debts
to member states of the euro area that were most and investment of citizens, stemming from their cur-
vulnerable to the debt crisis, alongside the possibility rent situation, in the period from 2001 to mid-2003.
of engaging the private sector in this area. A stronger monetary growth was perceived in
According to the analysis of general economic 2005, owing to the stimulative effect of low inter-
and monetary trends for 2012, inflation remained at est rates within the Eurozone. At the same time,
an acceptable level and in pace with the long-term discouraging growth effects of М3 (as presented in
goal. This is confirmed by the cross-analysis of sig- Graph 1), related to stabilized investment activity of
nals coming from the monetary sphere. Additional the Eurozone citizens, were losing its pace, especially
economic policy measures and the progress of Eu- in the first half of the year. In a nutshell, accelerated
ropean reforms can help sustain the financial senti- monetary growth in 2005 spurred further monetary
ment on the market and enhance the opportunities growth in the euro area.
for economic growth.
In 2006, monetary growth continued, reach-
ing, at the end of the year, the highest ever an-
MAIN FEATURES OF THE ECB MONETARY AND nual rate, since the beginning of EMU Phase 3.
FOREIGN CURRENCY POLICY IN THE PERIOD The Strong growth of М3 was largely a product of
2004-2012 low levels of interest rates and more vigorous eco-
nomic activity in the euro area, further propped
The ECB instruments and their effects and re- up by a strong expansion of credits extended to
sults, monetary-credit features and foreign currency the private sector.

Liabilities M1 M2 M3
Money in circulation X X X
Overnight deposits X X X
Deposits with agreed maturity of up to 2 years X X
Deposits redeemable at notice of up to 3 months X X
Repurchaseagreement X
Money market funds shares/units X
Debt securities issued with a maturity of up to 2 years X
Table 1: Monetary aggregates definition in Eurozone
Source: http://www.ecb.europa.eu/mopo/strategy/monan/html/index.en.html

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 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

Graph 1: EU М3 trends in the period 2004-2012

The wide basis of the monetary trends analysis edly. This only reinforced the ECB’s mid-term mon-
suggests that the growth of M3 to some extent can etary policy strategy.
excessively increase the rate of monetary expansion. The ECB’s monetary policy took a new turn in
Strong M3 growth can be guided by the theoretical 2011. Monetary expansion, from the years prior to
requirements of monetary values. the crisis, continued, the underlying objective hav-
A crucial turn of events, with regard to mone- ing been to help economic activities recover and
tary trends, came with the global economic crisis in come out of the recession zone. After a relatively low
2008 when it started, and especially at the beginning growth of M3 of 1.7% in 2010, monetary expansion
of 2009. Monetary expansion was moderate dur- in the euro area gradually accelerated in the first
ing 2008. The rough estimation of M3 components three quarters of 2011, reaching 2.9% in September
confirmed the existence of monetary growth, which 2011 (as it can be seen in Figure 2). Still, financial
was moderate at the time. Throughout the year, the market tensions and the pressure exerted on banks
growth of non-financial private sector loans slowed to adjust their annual balance sheets, particularly in
down, following the introduction of tighter borrow- the field of capital needs, undermined monetary dy-
ing requirements and a weaker economic activity. namics in the autumn and slowed down the overall
In 2009, the annual growth rate of М3 and loans annual growth rate, reducing it to 1.5% in Decem-
to the private sector slipped into the negative zone. ber. The profile of M3 growth in 2011 was under a
Economic recession, i.e. subdued production and strong impact of inter-banking transactions. There-
trade, as well as uncertainty of business prospects, fore, it can be concluded that monetary expansion
continued to push back companies’ demand for throughout the year was moderate.
financial resources. To a certain extent, a lack of The annual rate of M3 rose to 3.9% in October
financial resources, extended by banks, also played 2012, from 2.6% in September, while the growth of
an important role, as stated by analysts of bank М1 sped up to 6.4%, from 5.0% a month earlier.
loans in the euro zone. These trends, partially down to a specific nature
The growth of М3 was moderate in 2010, at an of the business, led to higher overnight deposits
average rate of 0.6%. This serves to confirm the as- which belong to the non-monetary financial sec-
sessment that monetary expansion was moderate tor. Household and non-financial corporation de-
and inflation pressures around the mid-year lim- posits increased in October.
ited. By that time, the monetary analysis used as the To sum up, the period under consideration can
basis for the analysis and the assessment of money be divided into three sub-periods that were charac-
supply and credit growth, had been improved mark- terized by different profiles of the monetary policy
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 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

and the money supply, as measured by the mon- direct fees. The annual inflation was kept at an ac-
etary aggregate М3. During the period of escalation ceptable level of 2.2% in 2005.
of the global economy crisis, 2008 inclusive, the An average annual rate of price increase reached
monetary policy was moderately expansive. In the 2.2% in 2006, almost the same level as in 2005,
following period, 2010 inclusive, monetary restric- which can be seen in Graph 2. The inflation rate
tion was introduced in order to suppress inflation was unstable throughout the year and it was mostly
pressures, with a subsequent revival of the monetary affected by changes in the price of oil.
expansion whose aim was to lead to the overcoming Annual inflation remained at 2.1% in 2007 as
of economic recession in the Eurozone. well. The inflation rate was quite unstable, just like
the year before, due to the impact of energy prices.
Inflation At the end of the year, the annual inflation went up
sharply to much above 2%. The increase was largely
caused by rising oil and food prices in the second
One of the main tasks of the ECB is to keep infla- half of 2007.
tion at the level of up to 2%. The ECB has striven to
In 2008, a relatively high inflation trend con-
reach that goal by pursuing an adequate monetary
tinued from the end of the previous year, due to
policy, and thus alleviate the impact of the global
large-scale effects of the crisis and the atmosphere
economic crisis and maintain stability.
of instability and strong inflationary expectations.
The inflation rate in 2004 was, to a great extent, An average annual inflation rate in 2008 rose to as
driven by an increase in administrative prices and much as 3.3%, considerably above the level the ECB
indirect fees and, in the second half of the year in had aspired to on a long-term basis; moreover, this
particular, a higher price of oil. Out of these reasons, was the highest level ever since the introduction of
the annual HICP (Harmonized Index of Consumer the euro. Under the influence of a restrictive ECB
Prices) inflation in 2004 remained at the same level, monetary policy, inflation pressures fell to 1.6% in
compared to the level of 2.1%, of the year before December.
(European Central Bank, 2005, p. 43). In 2009, the annual inflation rate first dropped
Long-term inflation expectations remained at a from 1.1% in January, to -0.7% in July, before it sped
level similar to the one associated with price stabil- up again to 0.9% in December. Major factors, that
ity. Inflation in 2005 was slightly faster, mostly due caused oscillations to the general price increase,
to the rising trend of energy prices and, to a limited were the increase in production prices and in prices
extent, the increase in administrative prices and in- of energy resources.

Graph 2: EMU Inflation rate in the period 2004 - 2012

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 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

Inflationary pressures lessened in the course of The ECB Council kept key interest rates un-
2010, primarily owing to a shift in the monetary changed during 2004, and that at historically low
policy toward monetary restriction in 2009, which levels. The lowest offered rate of ECB major refi-
resulted in an average annual inflation rate of 1.6% nancing operations was kept at 2%, while the rates
only. of deposit facilities and marginal facilities of lending
In 2011, inflation was constantly at a higher level, remained at 1% and 3%, respectively.
on average at 2.7%, as an effect of a restored mon- In 2006, the Council raised the key interest rates,
etary expansion that was designed to help the real in order to curb the risk of strong inflation pressures
economy overcome recession. As for the monthly that had been detected. Monetary adjustment took
profile of annual inflation, it gradually rose from place under conditions of economic growth and
2.3% in January, to the maximum of 3.0% in the pe- powerful money and credit expansion. In a series
riod from September to November, dropping again of expansion developments, the Council raised the
to 2.7% in December. Mid-term and long-term ex- minimal offered rate of major refinancing opera-
pectations, as regards inflation, remained steadily at tions of the euro-system from 2.25% in January, to
the targeted ECB levels.
3.50% by the end of 2006.
According to Eurostat data, annual inflation
The Council continued the adjustment of the
dropped to an acceptable level of 2.2% in Novem-
monetary policy, by raising the key interest rates
ber 2012. On the basis of current prices of oil fu-
by 50 index points in March and June, and so the
tures, a further fall to below 2% is expected in 2013.
By means of the policy relevant to the horizon, and minimal offered rates were increased to 4.00% in
under conditions of weak economic activity in the June 2007.
Eurozone, and well-anchored long-term inflation- When the global economic crisis escalated, the
ary expectations, price pressures will probably re- Council started the monetary relaxation, by lower-
main rather moderate. ing the reference interest rates. Firstly, it reduced
the rate of the major refinancing operation by 150
Interest rates base points, to 1%, and that in four stages. In May,
it decided to lower it to 1.75%, leaving the interest
The interest rate, set by the Governors Council, rate on deposit facilities at the same level, of 0.25.
presents the minimal tender rate, beyond which the Considering the effects of monetary relaxation,
European Central Bank would not accept offers sub- the ECB Council came to a conclusion that the pro-
mitted by financial institutions (Grauwe, 2005, p. 318). file of interest rates policy should not be altered

Graph 3: EMU Interest rates on the money market in the period 2004 - 2011 (% p.a.)
Source: http://sdw.ecb.europa.eu/servlet/quickviewChart?SERIES_KEY=143.FM.M.U2.EUR.RT.MM.EURIBOR1YD_.HSTA

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 SJAS 2014  11 (1)  16-24
Mladenović V., Hadžić M.  Monetary and foreign currency policy of the ECB

and, accordingly, left the key ECB interest rates at analyzed period. During the period of the global
an unchanged, historically low level, reached in May economic crisis escalation (2008 inclusive), monetary
2009. The interest rate on major refinancing opera- policy was moderately expansive. What ensued in the
tions was at 1.00% during 2010, the rate on deposit next period (2010 inclusive), was monetary restric-
facilities at 0.25%, and the rate on the marginal in- tion, the main objective of which was the curbing
terest facility at 1.75%. of inflation pressures. In the period that followed,
In 2011, the interest rate policy was slightly mod- monetary expansion was revivified, for the purpose
ified. In order to secure and maintain stability, the of overcoming the economic crisis in the Eurozone.
ECB Council raised basic interest rates in April and An adequate policy of reference interest rates
July 2011, by 25 percentage points each time. was an efficient lever of monetary regulation. The
analysis of the monetary policy profile and its basic
CONCLUSION instruments, including interest rates, and the analy-
sis of achieved results in the pursuit of the desired
goal – price stability, confirm that inflation will be
The paper pointed out that independent position within the target of below 2%, if the reference inter-
of a central bank is essentially important for a suc- est rate is regulated at 2%.
cessful monetary policy. There are several important
The dynamic analysis of the monetary policy,
elements which ensure independency of the ECB to
and results achieved during years of work, demon-
political influences, such as: institutional independ-
strate that the ECB has led an adequate monetary
ence, legal independence, functional and operation-
policy, which resulted in a successful accomplish-
al independence, financial and organizational inde-
ment of its objectives, for the most of the period
pendence. Increasing interest in the (in)dependency
analyzed, including the period of the economic cri-
of a central bank, in recent years, is the result of
sis escalation.
increasing interest in joining the Eurozone. At the
same time, economic theory argued that there is a
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pdf/annrep/ar2011en.pdf. Scheller, H.K. (2006). The European Central Bank: History,
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ECB. Frankfurt am Main: European Central Bank.

MONETARNA I DEVIZNA POLITIKA EVROPSKE CENTRALNE BANKE

Rezime:
Ovaj rad se bavi analizom uspešnosti Evropske centralne banke u sprovođenju
svoje monetarne i devizne politike, što je, istovremeno, jedan kompleksan zadatak,
od vitalnog značaja za opravdanost njenog postojanja. ECB, najpre, ulaže velike
napore da ide u korak sa svetskom krizom i da očuva stabilnost evra. Osnovni
zadatak Evropske centralne banke jeste da inflaciju zadrži ispod 2%, na godišnjem Ključne reči:
nivou. Ovaj rad pokazuje da je ECB uspela da održi inflaciju u traženim okviri- monetarna politika,
ma, tokom značajnog vremenskog perioda, sa nekoliko kratkotrajnih izuzetaka. Evropska centralna banka,
Uspostavljanjem adekvatne monetarne politike, ECB je uspešno ostvarila svoje inflacija,
ciljeve, u referentnom periodu, što je pokazano kroz rezultate trenda inflacije, kamatne stope,
monetarni agregat M3, kao i nivo kamatnih stopa. evro.

Received: November 13th, 2013.

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