PRI CE STABI LI TY:

WHY I S I T I MPORTANT
FOR YOU ?
2
CONTENTS
1 2 3 4 5
BOXES
3.1 Measuring inflation
a simple example 26
3.2 The relationship between expected
inflation and interest rates
the so-called Fisher effect 28
3.3 Hyperinflation 31
3.4 Demand for cash 32
Chapter 2
Money a short history 15
2. 1 Functi ons of money 16
2. 2 Forms of money 18
2
Chapter 1
Introducti on 11
1
Chapter 3
The i mportance of pri ce stabi l i ty 23
3. 1 What i s pri ce stabi l i ty? 24
3. 2 Measuri ng i nf l ati on 25
3. 3 The benef i ts of pri ce stabi l i ty 29
3
Foreword 5
Price stability:
why is it important for you? 6
Summary 6
3
BOXES
4.1 Why can central banks influence
(ex ante) real interest rates?
The role of sticky prices 39
4.2 How do changes in aggregate demand
affect economic activity and price
developments? 40
4.3 The quantity theory of money 47
Chapter 5
The ECBs monetary policy 49
5. 1 A short hi stori cal overvi ew 50
5. 2 The i nsti tuti onal framework 53
5. 3 The ECBs monetary policy strategy 57
5. 4 Overvi ew of the Eurosystems
operati onal framework 71
5
BOXES
5.1 The road to the single currency, the euro 51
5.2 Convergence criteria 54
5.3 Construction and features of the HICP 60
5.4 A safety margin against deflation 61
5.5 The medium-term orientation of the ECBs monetary policy 62
5.6 Real economic and financial indicators 64
5.7 Euro area macroeconomic projections 66
5.8 Monetary aggregates 67
5.9 The ECBs reference value for monetary growth 68
Chapter 4
Factors determining price developments 35
4. 1 What monetary pol i cy can and cannot do an overvi ew 36
4. 2 Money and i nterest rates how can monetary pol i cy
i nf l uence i nterest rates? 38
4. 3 How do changes i n i nterest rates af fect the expendi ture
deci si ons taken by consumers and f i rms? 38
4. 4 Factors driving price developments over
shorter-term horizons 44
4. 5 Factors driving price developments over
longer-term horizons 46
4
Gl ossary 74
Bi bl i ography 76
4
Thi s book has benefi ted greatly from numerous comments and drafti ng suggesti ons from my col l eagues
at the ECB, to whom I am most gratef ul . I woul d al so l i ke to express my grati tude to the members of
the External Communi cati ons Commi ttee of the European System of Central Banks (ESCB) and of the
Board of Experts, colleagues from the ECB' s Language Services Division, Official Publications and Library
Di vi s i on, Pres s and I nf or mat i on Di vi s i on, H. Ahner t , W. Bi er, D. Bl enck, J . Cuvr y,
G. Deschamps, L. Dragomi r, S. Ej erskov, G. Fagan, A. Ferrando, L. Ferrara, S. Keuni ng, H. J . Kl ckers,
D. Li ndenl aub, A. Loj schova, K. Masuch, W. Modery, P. Moutot, A. Page, H. Pi l l , C. Pronk, B. Roffi a,
C. Rogers, P. Sandars, D. Schacki s, H. J . Schl sser, G. Vi tal e, C. Zi l i ol i .
Dieter Gerdesmeier
Frankfurt am Main, January 2011
ACKNOWLEDGEMENTS
5
More than 330 million people in 17 European countries share the euro as their currency. The Governing
Counci l of the European Central Bank (ECB) i s responsi bl e for the si ngl e monetary pol i cy i n these
countri es, whi ch are known col l ecti vely as the euro area. The Eurosystem, compri si ng the ECB and the
nati onal central banks (NCBs) of the euro area countri es, has a cl ear mandate assi gned by the Treaty
establishing the European Community: its primary objective is to maintain price stability in the euro area.
In other words, the Governing Council of the ECB is mandated to preserve the purchasing power of the
euro. Thi s mandate ref l ects a broad consensus i n soci ety that, by mai ntai ni ng pri ce stabi l i ty, monetary
pol i cy contri butes si gni fi cantly to sustai nabl e growth, economi c wel f are and j ob creati on.
The Eurosystem has been granted i ndependence i n order to carry out i ts mandate. Furthermore, the
Governing Council has selected and made public its monetary policy strategy to deliver price stability, and
uses an efficient and well-functioning operational framework in order to conduct its single monetary policy.
In short, the Eurosystem has al l the tool s and ski l l s needed to conduct a successf ul monetary pol i cy.
Li ke any i mportant and i ndependent i nsti tuti on i n modern soci ety, the Eurosystem needs to be cl ose to
the general public and understood by the citizens of Europe. It is therefore important that its mandate and
policy are explained to a wide audience. This book aims to provide a comprehensive but easily accessible
overview of the reasons why price stability is so important in ensuring that prosperity is sustained and of
how the ECBs monetary pol i cy i s geared towards achi evi ng thi s mandate.
Jean-Claude Trichet
President of the European Central Bank
Jean-Claude Trichet
FOREWORD
6
SUMMARY
The Treaty establ i shi ng the European Communi ty
has assi gned the Eurosystem whi ch compri ses
the European Central Bank (ECB) and the national
central banks (NCBs) of those countries that have
adopted the euro as thei r currency the pri mary
mandate of maintaining price stability. This mandate
i s consi dered to be the pri nci pal obj ecti ve of the
Eurosystem for good economic reasons. It reflects
the lessons we have learnt from previous experience
and is supported by economic theory and empirical
research, whi ch i ndi cate that by mai ntai ni ng pri ce
stabi l i ty, monetary pol i cy wi l l make a si gni f i cant
contri buti on to general wel f are, i ncl udi ng hi gh
l evel s of economi c acti vi ty and empl oyment.
Gi ven the wi despread recogni ti on of the benef i ts
of price stability, we consider it essential to explain,
parti cul arly to young peopl e, the i mportance of
price stability, how it can best be achieved, and how
mai ntai ni ng i t supports the broader economi c
goal s of the European Uni on.
The benefi ts of pri ce stabi l i ty, as wel l as the costs
associ ated wi th i nf l ati on or def l ati on, are cl osely
associ ated wi th money and i ts f uncti ons. Chapter
2 is therefore devoted to the functions and history
of money. Thi s chapter expl ai ns that i n a worl d
wi thout money, i . e. i n a barter economy, the
costs associ ated wi th the exchange of goods and
s er vi ces , s uch as i nf or mat i on, s earch and
t ranspor t at i on cost s, woul d be ver y hi gh. I t
illustrates that money helps goods to be exchanged
more effi ci ently and therefore enhances the wel l -
bei ng of al l ci ti zens. These consi derati ons are
followed by a more detailed discussion of the role
and the three basi c f uncti ons of money. Money
serves as a medium of exchange, as a store of value
and as a uni t of account. The preci se forms of
money used i n di f ferent soci eti es have changed
over ti me. Commodi ty money, metal l i c money,
paper money and electronic money are particularly
noteworthy. The main developments in the history
of money are bri ef ly revi ewed and expl ai ned.
PRI CE S TABI LI TY: WHY I S I T
7
Chapter 3 focuses in more detail on the importance
of pri ce stabi l i ty. I t expl ai ns that i nfl ati on and
deflation are economic phenomena that could have
seri ous negati ve consequences for the economy.
The chapter begi ns wi th a def i ni ti on of these
concepts. In pri nci pl e, i nf l ati on i s defi ned as a
general i ncrease i n t he pri ces of goods and
servi ces over a protracted peri od, resul ti ng i n a
decl i ne i n t he val ue of money and t hus i t s
purchasi ng power. Def l ati on i s when the overal l
pri ce l evel f al l s over a protracted peri od.
Af ter a short secti on i l l ustrati ng some of the
problems associ ated wi th measuri ng i nfl ati on, the
chapter goes on to descri be the benefi ts of pri ce
stabi l i ty. Pri ce stabi l i ty supports hi gher l i vi ng
standards by reduci ng uncertai nty about general
pr i ce devel opment s , t hereby i mprovi ng t he
transparency of the pri ce mechani sm. It makes i t
easi er for consumers and compani es to recogni se
pri ce changes whi ch are not common to al l goods
(so-called relative price changes). Moreover, price
stabi l i ty contri butes to general wel l -bei ng by
reduci ng i nfl ati on ri sk premi a i n i nterest rates, by
renderi ng acti vi ti es whi ch ai m at hedgi ng agai nst
i nf l ati on ri sks unnecessary and by reduci ng the
di storti ve ef fects of taxati on systems and soci al
securi ty systems. Fi nal ly, pri ce stabi l i ty prevents
the arbi trary di stri buti on of weal th and i ncome
associ ated, for i nstance, wi th the erosi on of the
real value of nominal claims (savings in the form of
bank deposi ts, government bonds, nomi nal wages)
resul ti ng f rom i nfl ati on. Large erosi ons of real
weal th and i ncome due to hi gh i nf l ati on can be a
source of soci al unrest and pol i ti cal i nstabi l i ty.
To sum up, by mai ntai ni ng pri ce stabi l i ty, central
banks help broader economic goals to be achieved,
thus contri buti ng to general pol i ti cal stabi l i ty.
Chapter 4 focuses on the factors determining price
developments. Starting with a brief overview of the
role and limitations of monetary policy, it proceeds
to expl ai n how a central bank can i nf l uence
short-term i nterest rates. The central bank i s the
monopol i sti c (i . e. the only) suppl i er of banknotes
and central bank deposits. As banks need banknotes
for their clients and have to fulfil minimum reserve
requi rements (i. e. deposi ts) wi th the central bank,
they usual ly ask a central bank for credi t. The
central bank can set the interest rate on its loans to
the banks. Thi s subsequently i nf l uences the other
market i nterest rates.
The changes in market interest rates affect spending
deci si ons by househol ds and compani es and
therefore, ultimately, economic activity and inflation.
For i nstance, hi gher i nterest rates make i t more
expensi ve to i nvest and therefore tend to resul t
i n l ower expendi ture for i nvestment. They al so
general ly make savi ng more attracti ve and tend to
reduce consumpti on demand. So under normal
ci rcumstances i t can be expected that a ri se i n
interest rates will lead to a decline in consumption
and i nvestment expendi tures, whi ch al l other
thi ngs bei ng equal shoul d ul ti matel y l ower
i nfl ati onary pressures. Whi l e monetary pol i cy can
have some impact on real activity, this effect is only
transitory and not permanent. However, monetary
pol i cy has a l asti ng i mpact on pri ce devel opments
and, as a resul t, i nf l ati on.
I MPORTANT FOR YOU?
8
This chapter reviews in some detail the factors
dri vi ng the i nf l ati onar y process over shorter
hori zons. As i l l ustrated by a rather si mpl e model
descri bi ng the concepts of aggregate supply and
aggregate demand, a number of economi c f actors
can lead to movements i n price level s i n the short
term, among them i ncreases i n consumpti on and
investment, rising government budget deficits as well
as hi gher net exports. In addi ti on, hi gher i nput
pri ces (e. g. for energy) or wage i ncreases not
matched by producti vi ty gai ns can l ead to upward
pressures on i nfl ati on.
Agai nst thi s background, parti cul ar emphasi s i s
pl aced on the fact that monetary pol i cy cannot
f ul l y cont rol shor t - term pri ce devel opment s.
However, the chapter al so expl ai ns that, when
taki ng a l onger-term perspecti ve, i nf l ati on i s a
monetary phenomenon. It i s therefore undeni abl e
that monetary pol i cy, by respondi ng to ri sks to
price stability, can control inflation over medium to
l ong-term hori zons.
The closing chapter contains a short description of
the monetary policy of the ECB. Following a closer
l ook at the process l eadi ng to Economi c and
Monetary Uni on, the subsequent secti ons deal
wi th the i nsti tuti onal f ramework of the si ngl e
monet ar y pol i cy, t he ECBs monet ar y pol i cy
strategy and the monetary pol i cy i nstruments
used by the Eurosystem. I n order to cl ari f y the
Euros ys t ems obj ect i ve of mai nt ai ni ng pr i ce
stabi l i ty, as l ai d down i n the Treaty, the Governi ng
Council of the ECB gave the following quantitative
defi ni ti on i n 1998: Pri ce stabi l i ty shal l be defi ned
as a year-on-year increase in the Harmonised Index
of Consumer Pri ces (HI CP) for the euro area of
bel ow 2 %. Pri ce stabi l i ty i s to be mai ntai ned over
the medi um term.
Furthermore, the Governing Council made it clear
i n May 2003 that, wi thi n thi s defi ni ti on, i t ai ms to
keep i nf l ati on rates bel ow but cl ose to 2 % over
the medi um term.
In the ECBs strategy,
monetary policy decisions are
based on a comprehensive
analysis of the risks to price
stability.
PRI CE S TABI LI TY: WHY I S I T
I MPORTANT FOR YOU?
In the ECBs strategy, monetary pol i cy deci si ons
are based on a comprehensive analysis of the risks
to price stability. Such an analysis is performed on
the basi s of two compl ementary perspecti ves
for determi ni ng pri ce devel opments. The fi rst i s
ai med at assessi ng the short to medi um-term
determi nants of pri ce devel opments, wi th a focus
on real economi c acti vi ty and fi nanci al condi ti ons
i n the economy. It takes account of the f act that
over those horizons, price developments are heavily
i nfl uenced by the i nterpl ay of supply and demand
i n the goods, servi ces and i nput (i . e. l abour and
capi tal ) markets. The ECB refers to thi s as the
economi c anal ysi s. The second perspecti ve,
referred to as the monetary analysi s, focuses on
a l onger-term hori zon, expl oi ti ng the l ong-term
l i nk between the quanti ty of money i n ci rcul ati on
and prices. The monetary analysis serves mainly as
a means of cross-checki ng, over a medi um to
l ong-term perspecti ve, the short to medi um-term
indications for monetary policy stemming from the
economi c analysi s.
Based on thi s assessment, the Governi ng Counci l
of the ECB deci des on the l evel of short-term
i nterest rates to ensure that i nf l ati onary and
defl ati onary pressures are counteracted and that
pri ce stabi l i ty i s mai ntai ned over the medi um
term.
9
1
I NTRODUCTI ON
When asked about general economic
conditions in opinion polls, European citizens
usually express their desire to live in an
environment without inflation or deflation.
The Treaty establishing the European
Community has given the Eurosystem
the mandate to maintain price stability.
This makes good economic sense.
It reflects the lessons we have learnt from
history and is supported by economic theory
and empirical research, which suggest that,
by maintaining price stability, monetary
policy will contribute most to general
economic welfare, including high levels
of economic activity and employment.
Given the widespread recognition of the benefits of
pri ce stabi l i ty, i t i s i mportant that everyone, and
young peopl e i n par t i cul ar, underst ands t he
i mportance of pri ce stabi l i ty, how i t can best be
achi eved, and how mai nt ai ni ng st abl e pri ces
supports the broader economi c goal s of the
European Uni on. Thi s book consi sts of vari ous
chapters: each of them contai ns basi c i nformati on
and can be referred to i ndi vi dual ly, as and when
requi red. The degree of compl exi ty i s, however,
hi gher i n Chapters 4 and 5 than i n the f i rst few
chapters. In order to understand f ul ly Chapter 5,
i t i s necessary to have read Chapter 3 and, i n
particular, Chapter 4 carefully. Additional boxes are
provi ded to address some speci f i c i ssues i n more
detai l .
The benef i t s of pri ce st abi l i t y, or t he cost s
associ ated with inflation or deflation, are closely
linked to money and i ts f uncti ons. Chapter 2 i s
therefore devoted to the functi ons and hi story of
money. The chapter explains that in a world without
money, i.e. in a barter economy, the transacti on
costs associ ated wi th the exchange of goods and
servi ces are very hi gh. I t al so i l l ustrates that
money hel ps to achi eve a more effi ci ent exchange
of goods and thereby enhances the wel fare of
consumers. These consi derati ons are fol l owed by
a more detai l ed di scussi on of the rol e and the
basic functions of money in Section 2.1. The forms
of money used in societies have changed over time.
The mai n hi stori cal devel opments are bri ef l y
revi ewed and expl ai ned i n Secti on 2. 2.
Chapt er 3 expl ai ns t he i mpor t ance of pri ce
stabi l i ty. I t f i rst def i nes the concepts of i nf l ati on
and def l ati on (Secti on 3. 1). Af ter a short secti on
i l l ustrati ng some measurement i ssues (Secti on
3. 2), the next secti on descri bes the benef i ts of
pri ce s t abi l i t y and, convers el y, t he negat i ve
consequences of i nf l ati on (or def l ati on) i n detai l
(Secti on 3. 3).
12
2 1 3 5 4
I NTRODUCTI ON
13
Chapter 4 focuses on the factors determining price
devel opments. Begi nni ng wi th a bri ef overvi ew
(Section 4.1), it proceeds to investigate the influence
of monetary policy on interest rates (Section 4.2).
Subsequently the effects of interest rate changes on
expendi ture deci si ons by househol ds and f i rms
(Secti on 4. 3) are i l l ustrated. In the next secti on,
the factors dri vi ng the i nf l ati onary process over
the shorter term are revi ewed (Secti on 4. 4).
Parti cul ar emphasi s i s pl aced on the fact that
monetary pol i cy al one does not control short-
term pri ce devel opments, as a number of other
economi c factors can have an i mpact on i nfl ati on
within this timescale. However, it is acknowledged
that monetary pol i cy control s i nfl ati on over the
l onger term (Secti on 4. 5).
The closing chapter contains a short description of
the ECBs monetary policy. Following a closer look
at the process l eadi ng to Economi c and Monetary
Uni on (Secti on 5. 1), the subsequent secti ons deal
wi th the i nsti tuti onal f ramework of the si ngl e
monetary policy (Section 5.2), the ECBs monetary
poli cy strategy (Secti on 5. 3) and the Eurosystems
operati onal f ramework (Secti on 5. 4).
For more det ai l ed i nf ormat i on, pl eas e
consul t the Gl ossary and Bi bl i ography at
the end of thi s book.
This book consists
of various chapters:
each of them contains
basic information and can
be referred to individually,
as and when required.
1
MONEY A S HORT HI S TORY
Money is an indispensable part of modern
life. This chapter attempts to deal with
questions such as what money is, why we
need money, why money is accepted and
for how long money has existed.
explains the functions
of money.
provides an overview of the various
goods that have served as money
in the past.
2.1
2.2
2
FUNCTI ONS
OF MONEY
History of the word money
Money pl ays a key rol e i n todays economi es. I t i s
certainly no exaggeration to say that money makes
the worl d go round and that modern economi es
coul d not functi on wi thout money. The Engl i sh
word money is of Roman origin. In ancient Rome,
however, the word Monetor or Moneta meant
advi sor, i . e. a person who warns or who makes
people remember. According to some historians, the
meani ng of the word goes back to a key event i n
Roman history. A flock of geese in a sanctuary of the
Goddess Juno on Capitoline Hill squawked an alarm
to alert the Roman defenders during an invasion of
the Gaul s i n 390 B. C. and thus saved them f rom
defeat. In return, the Romans bui l t a shri ne to
Moneta, the goddess who warns or who gi ves
advi ce. In 289 B. C. the fi rst Roman mi nt was bui l t
in or near this temple, initially producing bronze and
later silver coins. Many of these coins were cast with
the head of Juno Moneta on thei r face. Hence the
words money and mi nt are deri ved f rom her
name.
Functions of money
What i s money? If we have to defi ne money today,
we first think of banknotes and coins. These assets
are regarded as money si nce they are l i qui d. Thi s
means that they are accepted and are avai l abl e to
be used for payment purposes at any time. While it
i s uncontested that banknotes and coi ns ful fi l thi s
purpose, nowadays a number of other forms of
assets exist which are very liquid and can be easily
converted i nto cash or used to make a payment at
very low cost. This applies, for instance, to overnight
deposi ts and some other forms of deposi ts hel d
wi th banks.
1
Consequently, these instruments are
included in those definitions of money often referred
to as broad money.
The var i ous f or ms of money have changed
substanti al ly over ti me. Paper money and bank
deposits did not always exist. It would therefore be
usef ul to def i ne money i n more general terms.
Money can be thought of as a very special good that
ful fi l s some basi c functi ons. In parti cul ar, i t shoul d
serve as a medium of exchange, a store of value and
a unit of account. Therefore, it is often stated that
money i s what money does.
1 Overnight deposits are funds which are immediately available
for transaction purposes. It should be mentioned that electronic
money on prepaid cards is included in overnight deposits.
2.1
2 1 3 5 4
2.1 Functions of money
2.2 Forms of money
16
MONEY A S HORT
In order to better illustrate these functions, consider
how peopl e had to conduct thei r transacti ons
before the exi stence of money. Wi thout money,
people were forced to exchange goods or services
di rectl y f or other goods or ser vi ces through
bartering. Although such a barter economy allows
for some di vi si on of l abour, there are practi cal
l i mi tati ons and any exchange of goods i mpl i es
substanti al so-cal l ed transacti on costs.
The most apparent problem with a barter economy
is that people have to find a counterpart who wants
exactly the same good or servi ce that they are
of feri ng and who i s offeri ng what they want i n
ret urn. I n ot her words : a s ucces s f ul bar t er
transacti on requi res a mutual coi nci dence of
wants to exist. A baker who, for instance, wanted a
haircut in exchange for some loaves of bread would
have to f i nd a hai rdresser wi l l i ng to accept those
loaves of bread in exchange for a haircut. However,
i f the hai rdresser needed a pai r of shoes i nstead,
he woul d have to wai t unti l a shoe-shop owner
wanted to get a haircut in exchange. Such a barter
economy woul d therefore i mply substanti al costs
related to searching for the appropriate counterpart
and wai ti ng and stockpi l i ng.
Money as a medium of exchange
To avoi d the i nconveni ences associ ated wi th a
barter economy, one of the goods can be used as
a medi um of exchange. Thi s crude form of money
used for exchange is then called commodity money.
Bartering one good against money and then money
agai nst another good mi ght at fi rst gl ance further
complicate transactions. At second glance, however,
i t becomes cl ear that the use of one good as a
medi um of exchange faci l i tates the whol e process
to a considerable extent, as the mutual coincidence
of wants i s no l onger requi red for an exchange of
goods and services to take place. It is obvious that
one precondition for this particular good to fulfil the
function of money is that it is accepted throughout
the economy as a medium of exchange, be it because
of tradi ti on, i nformal conventi on or l aw.
At the same ti me, i t i s obvi ous that goods servi ng
as a medium of exchange should have some specific
technical properties. In particular, goods serving as
commodity money should be easy to carry, durable,
di vi si bl e and thei r qual i ty shoul d be easy to veri fy.
In a more economic sense, of course, money should
be a rare good, as only rare goods have a posi ti ve
val ue.
Money as a store of value
I f the good used as money mai ntai ns i ts val ue
over time, it can be held for longer periods. This is
parti cul arly usef ul because i t al l ows the act of
sal e to be separated f rom the act of purchase. I n
thi s case, money ful f i l s the i mportant f uncti on of
a store of val ue.
I t i s for these reasons that commodi ti es that
al so serve as a store of val ue are preferabl e to
commodi ti es that onl y serve as a medi um of
exchange. Goods such as fl owers or tomatoes, for
i nstance, mi ght i n pri nci pl e serve as a medi um of
exchange. However, they woul d not be useful as a
store of val ue and woul d therefore probably not
have been used as money. So i f thi s f uncti on of
money does not work properly (for instance if the
good servi ng as money l oses i ts val ue over ti me),
people will make use of the val ue-storing function
of other goods or assets or i n extreme cases
even go back to barteri ng.
17
2
The English word money
is of Roman origin.
HI S TORY
Money should serve as a
medium of exchange, a store
of value and a unit of
account.
18
Money as a unit of account
Of equal importance is the function of money as a
unit of account. This can be illustrated by going back
to our previous example. Even if the difficulty of the
mutual coi nci dence of wants i s overcome, peopl e
woul d sti l l have to f i nd the exact exchange rati o
between bread and hai rcuts or between hai rcuts
and shoes, for example. Such exchange ratios the
number of l oaves of bread worth one hai rcut, for
instance are known as relative prices or terms of
trade. In the market place, the relative price would
have to be determi ned for each pai r of goods and
servi ces and, of course, everybody i nvol ved i n the
exchange of goods woul d need al l the i nformati on
about the terms of trade between all goods. It is easy
to show that, for two goods, there i s only one
relative price, while for three goods there are just
three relative prices (namely bread against haircuts,
hai rcuts against shoes and bread agai nst shoes). In
the case of ten goods, however, there are al ready
45 relative prices, and with 100 goods the number
of relative prices amounts to 4950.
2
Therefore, the
greater the number of goods bei ng exchanged,
the more difficult it becomes to gather information
on al l possi bl e exchange rates. Consequently,
col l ecti ng and rememberi ng i nformati on on the
terms of trade creates high costs for the participants
in a barter economy, increasing disproportionately
wi t h t he number of goods exchanged. These
resources can be used more ef f i ci ently i n other
ways if one of the existing goods is used as a unit of
account (a so-called numeraire). In this case, the
value of all goods can be expressed in terms of this
numerai re and the number of pri ces whi ch
consumers have to i denti f y and remember can be
reduced si gni fi cantly.
3
Therefore, i f al l pri ces were l abel l ed i n money
terms, transacti ons woul d be much easi er. More
general ly speaki ng, not onl y can the pri ces of
goods be expressed i n money terms, but so too
can the pri ce of any asset. Al l economi c agents i n
a currency area would then calculate things such as
costs, pri ces, wages, i ncome, etc. i n the same
uni t s of money. As i n t he above- ment i oned
functions of money, the less stable and reliable the
val ue of money, the more di f fi cul t i t i s for money
to f ul f i l thi s i mportant f uncti on. A commonl y
accepted rel i abl e uni t of account thus forms a
sound basis for price and cost calculations, thereby
i mprovi ng transparency and rel i abi l i ty.
FORMS
OF MONEY
Over ti me, the nature of goods servi ng as money
has changed. It is widely agreed that what at times
became the prime function of these goods was often
not the same as their original purpose. It seems that
goods were chosen as money because they could be
stored conveniently and easily, had a high value but
a comparably low weight, and were easily portable
and durable. These widely desired goods were easy
to exchange and therefore came to be accepted as
money. So the evol uti on of money depends on a
number of factors, such as the relative importance of
trade and the state of development of the economy.
Commodity money
A variety of items have served as commodity money,
including the wampum (beads made from shells) of
the Ameri can I ndi ans, cowri es (bri ghtly col oured
shells) in India, whales teeth in Fiji, tobacco in the
early col oni es i n North Ameri ca, l arge stone di scs
on the Paci f i c I sl and of Yap and ci garettes and
l i quor i n post-Worl d War II Germany.
2.2
MONEY A S HORT
2 More generally, for n goods, there are
n x (n 1)
relative prices.
________
2
3 Namely to n 1 absolute prices.
19
Metallic money
The i ntroducti on of metal l i c money was a way
by whi ch anci ent soci eti es tri ed to overcome
t he probl ems associ at ed wi t h usi ng decayi ng
commodities as money. It is not known exactly when
and where metal l i c money was used for the fi rst
ti me. What i s known, however, i s that metal l i c
money was i n use i n around 2000 B. C. i n Asi a,
al though i n those ti mes i ts wei ght does not seem
to have been standardised nor its value certified by
the rul ers. Chunks or bars of gol d and si l ver
were used as commodi ty money si nce they were
easy to transport, did not decay and were more or
l ess easi ly di vi si bl e. Moreover, i t was possi bl e to
mel t them i n order to produce j ewel l ery.
Metallic coins
Europeans were among t he f i rst t o devel op
standardi sed and certi f i ed metal l i c coi ns. The
Greeks i ntroduced si l ver coi ns around 700 B. C. ;
Aegina (595 B. C.), Athens (575 B. C.), and Corinth
(570 B. C.) were the first Greek city-states to mint
their own coins. The silver content of the Athenian
drachma, f amous for depi cti ng the l egendary owl ,
remai ned stabl e for nearly 400 years. Greek coi ns
were therefore widely used (their use was further
spread by Al exander the Great), and have been
found by archaeol ogi sts i n a geographi cal area
rangi ng f rom Spai n to modern Indi a. The Romans,
who had previ ousl y used cumbersome bronze
bars cal l ed aes si gnatum as money, adopted the
Greek i nnovati on of usi ng off i ci al coi ns and were
the first to introduce a bi-metal scheme using both
the si l ver denari us and the gol d aureus.
Under the Emperor Nero in the first century A. D.,
the precious metal content of the coins started to
di mi ni s h as t he i mper i al mi nt s i ncreas i ngl y
substi tuted gol d and si l ver for al l oy i n order to
f i nance the Empi res gi ganti c def i ci t. Wi th the
i ntri nsi c val ue of the coi ns decl i ni ng, the pri ces of
goods and services began to rise. This was followed
by a general rise in prices that may have contributed
to the downfall of the Western Roman Empire. The
more stable Eastern Roman solidus, introduced by
Constantine the Great in the fourth century A. D.,
was mai ntai ned at i ts ori gi nal wei ght and preci ous
metal content until the middle of the 11th century,
thus gai ni ng a reputati on that made i t the most
important coinage for international trade for over
f i ve centuri es. Byzanti ne Greek coi ns were used
as i nt er nat i onal money and were f ound by
archaeol ogi sts as f ar away as Al tai i n Mongol i a.
I n the mi d-11th century, however, the Byzanti ne
monetary economy col l apsed and was repl aced by
a new s ys t em whi ch l as t ed t hroughout t he
12th century, unti l the Crusader conquest of
Constanti nopl e i n 1204 eventual l y ended the
hi story of Graeco-Roman coi nage.
The Greeks and Romans had spread the custom of
using coins and the technical knowledge of how to
strike them over a vast geographical area. For most
of the Mi ddl e Ages l ocal ly mi nted gol d and si l ver
coi ns were t he domi nant means of payment ,
al though copper coi ns were i ncreasi ngl y bei ng
used. I n 793 A. D. Charl emagne ref ormed and
st andardi sed t he Franki sh monet ar y syst em,
i ntroduci ng a monetary standard accordi ng to
whi ch one Franki sh si l ver pound (408g) equal l ed
20 shillings or 240 pence this standard remained
valid in the United Kingdom and Ireland until 1971.
After the fall of Constantinople, the Italian merchant
city-states of Genoa and Florence introduced gold
coi nage i n 1252 wi th the genoi n of Genoa and the
fi ori na (or fl ori n) of Fl orence. In the 15th century
thei r pl ace was taken by the ducato of Veni ce.
2
A variety of items
have served as commodity
money for example
brightly coloured shells.
HI S TORY
20
Paper money
The Chinese began using paper money around 800
A. D. under Emperor Hien Tsung and continued to do
so for several hundred years. This paper money had
no commodity value and was money only by imperial
decree, or so-called fiat money (i.e. money without
intrinsic value). Paper money was most widespread
i n Chi na around 1000 A. D. , but i t was abandoned
around 1500 when Chi nese soci ety went i nto
decl i ne fol l owi ng the Mongol Conquest.
Obligations
It was, however, di ffi cul t to conduct l ong-di stance
trade as l ong as val ue coul d only be stored i n the
form of commodi ti es and coi ns. The I tal i an ci ty-
st at es were t heref ore the f i rst to i nt roduce
certi f i cates of i ndebtedness (obl i gati ons or
bi l l s of exchange) as a means of payment.
To reduce the ri sk of bei ng robbed on thei r
j ourneys, merchants took these obl i gati ons wi th
them. Debtor and l ender were menti oned i n the
certi fi cates, a payment date was fi xed, and the
amount of gol d or si l ver noted. Soon, merchant
bankers began to trade these obligations. The first
evi dence of such a contract dates back to 1156.
Obligations continued to be used mostly by Italian
merchants, and the bi -metal scheme remai ned
domi nant unti l the Thi rty Years War. Due to the
economic turmoil caused by the war, rulers such as
the Swedi sh ki ngs started to prefer paper money.
Thi s was subsequently i ntroduced by the Bank of
England in 1694 and the Banque gnrale in France
i n 1716. The advent of paper fi at money i n Europe
marked the begi nni ng of a new phase i n the
evol uti on of money.
The responsi bi l i ty for establ i shi ng and regul ati ng
the system of f i at money i n a country remai ned
wi th the governments, but other publ i c or pri vate
institutions such as central banks and the financial
system pl ayed an i ncreasi ngly cruci al rol e i n the
success of the nati onal currency.
Gold standard
Since the adoption of fiat money approximately two
centuries ago, the monetary system has undergone
great change. Paper money was and still is legal
tender only by an act of the competent authority. It
was issued in fixed units of national currency and had
a clearly defined nominal value. For a long time, the
nation states held gold reserves in their central banks
to ensure the credibility of their currency a system
known as the Gold Standard. Currencies in the form
of coins and fiduciary paper notes were convertible
into gold at a fixed parity. The United Kingdom was
effectively the first country to set up a gold standard
in 1816, the exchange rate of pounds into gold
having been determined in 1717 at 3.811 pounds
sterling per ounce by Sir Isaac Newton himself.
Wi th the start of Worl d War I , many countri es
began pri nti ng more and more money i n order to
f i nance the cost of the war. I n Germany, f or
i nstance, the number of banknotes i ssued by the
Rei chsbank grew f rom 2, 593 mi l l i on i n 1913 to a
t ot al of 92, 844, 720. 7 bi l l i on banknot es i n
ci rcul ati on on 18 November 1923. Thi s ul ti mately
l ed t o hyper i nf l at i on.
4
Wi t h more money
ci rcul at i ng, mos t count r i es s us pended t he
converti bi l i ty of thei r currenci es i nto gol d, as i ts
i ncreased quanti ty was no l onger bal anced by the
nati onal gol d reserves.
4 See Davies (1994, p. 573) for a more detailed overview.
MONEY A S HORT
The Chinese began
using paper money around
800 A. D. and continued to
do so for several hundred
years.
These days, various
forms of intangible money
have emerged, among them
so-called electronic money.
21
Gold exchange standard
The British gold standard finally collapsed in 1931,
but the system was revived at the 1944 international
conference held in Bretton Woods, New Hampshire.
Here, a revised gold standard was agreed upon: the
exchange rates of the nati onal currenci es of the
major economic powers were pegged to the dollar
and the dol l ar was converti bl e i nto gol d at a fi xed
pri ce of USD 35 per ounce. The Bretton Woods
monetary system is therefore sometimes called the
gold exchange standard. Central banks stood ready
to provide dollars in exchange for their national
currency and vi ce versa.
The Bretton Woods monetary system col l apsed
i n 1971 and si nce then the currenci es of the
maj or economi es have remai ned pure fi at money.
I n addi ti on, most countri es have al l owed the
exchange rates of thei r currenci es to fl oat.
The evol uti on of money has not stopped. These
days, vari ous f orms of i ntangi bl e money have
emerged, among them so-called electronic money
(e-money), or el ectroni c means of payment,
whi ch f i rst appeared i n the 1990s. Thi s ki nd of
money can be used to pay for goods and servi ces
on the i nternet or usi ng other el ectroni c medi a.
Upon recei vi ng authori sati on from the buyer for
the payment to take place, the vendor contacts the
i ssui ng bank and i s transf erred the f unds. At
present there are vari ous card-based el ectroni c
money schemes i n Europe, general ly operated by
fi nanci al i nsti tuti ons.
2
The nation states held gold
reserves in central banks
to ensure the credibility
of their currency.
HI S TORY
THE I MPORTANCE
OF PRI CE S TABI LI TY
This chapter provides detailed information
to help answer questions such as what price
stability, inflation and deflation are, how
inflation is measured, what the difference
between nominal interest rates and the
real return is, and what the benefits of
price stability are, or in other words, why
it is important for central banks to ensure
price stability.
explains some basic economic terms
such as the concepts of inflation,
deflation and price stability.
focuses on the problems associated
with measuring inflation.
provides an overview of the benefits
of price stability.
3.1
3.2
3.3
3
WHAT I S
PRI CE STABI LI TY?
Inflation and deflation
Infl ati on and def l ati on are i mportant economi c
phenomenona that have negative consequences for
the economy. Basi cal ly, i nf l ati on i s def i ned as a
general, or broadly-based, increase in the prices of
goods and ser vi ces over an extended peri od
which consequently leads to a decline in the value
of money and thus i ts purchasi ng power.
Deflation is often defined as the opposite of inflation,
namely as a situation in which the overall price level
fal l s over an extended peri od.
When there is no inflation or deflation, we can say
that there is price stability if, on average, prices
neither i ncrease nor decrease but stay stabl e over
ti me. If, for i nstance, EUR 100 can buy the same
basket of goods as it could, say, one and two years
ago, then thi s can be cal l ed a si tuati on of absol ute
pri ce stabi l i ty.
Movements in individual prices
and in the general price level
I t i s i mportant to make a di sti ncti on between
movements i n pri ces of any i ndi vi dual good or
servi ce and movements i n the general pri ce l evel .
Frequent changes i n i ndi vi dual pri ces are qui te
normal i n market-based economi es, even i f there
i s pri ce stabi l i ty overal l . The changes i n supply
and / or demand condi ti ons of i ndi vi dual goods
or servi ces i nevi tably l ead to changes i n thei r
pri ce. For exampl e, i n recent years we have seen
substanti al decl i nes i n the pri ces of computers
and mobi l e phones, mai nly resul ti ng f rom rapi d
t echnol ogi cal progres s . However, f rom t he
begi nni ng of 1999 to mi d-2006, oi l and other
energy pri ces i ncreased, partl y as a resul t of
concerns regarding the future supply of energy and
partly as a resul t of i ncreased demand for energy,
in particular from fast-growing economies. On the
whol e, i nf l ati on i n most i ndustri al i sed countri es
remai ned l ow and stabl e stabi l i ty i n the general
pri ce l evel can go hand-i n-hand wi th substanti al
changes i n i ndi vi dual pri ces as l ong as f al l i ng and
ri si ng pri ces of f set each other so that the overal l
pri ce l evel remai ns unchanged.
3.1
2 1 3 5 4
3.1 What is price stability?
3.2 Measuring inflation
3.3 The benefits of price stability
THE I MPORTANCE OF PRI CE
24
MEASURI NG
I NFLATI ON
Measurement issues
How can inflation be measured? There are millions
of individual prices in an economy. These prices are
subj ect t o cont i nuous moves whi ch basi cal l y
reflect changes in the supply of and the demand for
i ndi vi dual goods and ser vi ces and t hus gi ve
an i ndi cati on of the rel ati ve scarci ty of the
respective goods and servi ces. It i s obvious that it
is neither feasible nor desirable to take all of these
prices into account, but neither is it appropriate to
l ook at j ust a few of them, si nce they may not be
representati ve of the general pri ce l evel .
Consumer Price Index
Most countri es have a si mpl e common-sense
approach to measuri ng i nf l ati on, usi ng the so-
called Consumer Pri ce Index (CPI).
5
For thi s
purpose, the purchasing patterns of consumers are
analysed to determi ne the goods and servi ces
whi ch consumers typi cal l y buy and whi ch can
t heref ore be cons i dered as s omehow
representati ve of the average consumer i n an
economy. As such they do not only i ncl ude those
i tems whi ch consumers buy on a day-to-day basi s
(e. g. bread and fruit), but also purchases of durable
goods (e. g. cars, PCs, washi ng machi nes, etc. ) and
frequent transactions (e. g. rents). Putting together
this shopping list of items and wei ghti ng them
according to their importance in consumer budgets
leads to the creation of what i s referred to as a
market basket.
6
Each month, a host of pri ce
surveyors checks on the pri ces of these i tems i n
vari ous outl ets. Subsequently, the costs of thi s
basket are then compared over ti me, determi ni ng
a seri es for the pri ce i ndex. The annual rate of
i nfl ati on can then be cal cul ated by expressi ng the
change i n the costs of the market basket today as
a percentage of the costs of the i denti cal basket
the previ ous year.
However, the devel opments of the pri ce l evel as
identified by such a basket only reflect the situation
of an average or representati ve consumer. I f a
persons buying habits differ substantially from the
average consumpti on pattern and thus f rom the
market basket on whi ch the i ndex i s based, that
person may experience a change in the cost of living
that i s di f ferent to the one shown i n the i ndex.
There wi l l therefore always be some peopl e who
experi ence a hi gher i nf l ati on rate f or thei r
i ndi vi dual basket and some who f ace a l ower
i ndi vi dual rate of i nf l ati on. In other words, the
i nf l at i on meas ured by t he i ndex i s onl y an
approxi mate measure of the average si tuati on i n
the economy; it is not identical to the overall price
changes f aced by each i ndi vi dual consumer.
3.2
S TABI LI TY
25
3
5 In fact, the Consumer Price Index, which measures the price
changes in consumer goods and services, is not the only price
index in an economy. Another index which is of similar economic
importance is the Producer Price Index. This index measures the
changes made by domestic producers of goods and services to
sales prices over time.
6 More precisely, these goods are weighted according to final
monetary expenditure shares of private households. In practice,
the weights in the basket are periodically revised in order to
reflect changes in consumer behaviour.
26
Measurement problems
For vari ous reasons, there are some di f f i cul ti es
associated with any attempt to express the overall
change i n pri ces as one number.
Fi rst, an exi sti ng basket usual ly becomes l ess and
l ess represent at i ve over t i me, as consumers
i ncreasi ngly substi tute more expensi ve goods for
cheaper ones. For exampl e, hi gher petrol pri ces
mi ght l ead some peopl e to dri ve l ess and buy a
hi gher quanti ty of other goods i nstead. Therefore,
i f the wei ghts are not adj usted, the change i n the
i ndex may sl i ghtly overesti mate the true pri ce
increases. Second, changes in quality are sometimes
di ffi cul t to i ncorporate i nto the pri ce i ndex. If the
qual i ty of a product i mproves over ti me and the
price also rises, some of the change in price is due
to the i mproved qual i ty. Pri ce i ncreases whi ch are
due to qual i ty changes cannot be consi dered as
gi vi ng ri se to i nf l ati on, as they do not reduce the
purchasi ng power of money. Changes i n qual i ty
are commonpl ace over l ong peri ods of ti me. For
example, todays cars differ considerably from those
manufactured in the 1970s, which in turn were very
different from those of the 1950s. Statistical offices
spend a lot of time making adjustments for quality
changes, but by their very nature such adjustments
are not easy to estimate. Apart from new varieties
of exi sti ng goods (e. g. the i ntroducti on of new
breakf ast cereal s) , an i mportant and di f f i cul t
THE I MPORTANCE OF PRI CE
BOX 3.1: MEASURI NG I NFLATI ON A SI MPLE EXAMPLE
Sandwi ches
Quantity Pri ce (Year 1) Pri ce (Year 2) Pri ce (Year 3)
100 EUR 1.00 EUR 1.20 EUR 0.90
Sof t dri nks 50 EUR 0.50 EUR 0.40 EUR 0.70
Energy dri nks 10 EUR 1. 50 EUR 1.70 EUR 1.20
Mountai n bi ke 1 EUR 160. 00 EUR 173.00 EUR 223.00
Cost of the
market basket
EUR 300. 00 EUR 330.00 EUR 360.00
Pri ce i ndex 100. 00 110. 00 120. 00
Let us illustrate the considerations above by means
of a si mpl e numeri cal exampl e. Suppose that a
repres ent at i ve mar ket bas ket of t he year l y
expenditure of teenagers is 100 sandwiches, 50 soft
dri nks, ten energy dri nks and one mountai n bi ke.
that between the first and second year, the cost of
thi s basket of goods has ri sen f rom EUR 300 to
EUR 330, or by 10 %. From the first to the third year,
the cost has risen from EUR 300 to EUR 360, or by
the equi val ent of 20 %.
Another way to express this is by means of a price
i ndex. I n order to compute the pri ce i ndex, the
cost of the market basket i n any peri od i s di vi ded
by the cost of the market basket in the base period,
and the resul t i s mul ti pl i ed by 100. I n the tabl e
above, year 1 i s the base peri od. The pri ce i ndex
for year 3 i s therefore:
Pri ce Index = (P3/P1) x 100 = (360/300) x 100 = 120
The pri ce i ndex tri es to gi ve a general pi cture of
what i s happeni ng to a great many pri ces. As the
exampl e shows, the pri ce i ndex may ri se despi te
some pri ces actual ly decl i ni ng.
The total cost of the basket can then be calculated
by mul ti plyi ng the quanti ti es by the respecti ve
pri ces and addi ng everythi ng up. I t i s easy to see
27
subj ect i s the i ncl usi on of new products. For
exampl e, af ter DVD pl ayers came on the market,
there was an inevitable time lag until they could be
captured i n pri ce stati sti cs, si nce i nformati on on
the market shares, the mai n di stri buti on channel s,
the most popul ar makes, etc. , was needed. But i f
it takes too long to incorporate new products into
the price index, the price index fails to fully reflect
the actual average pri ce changes that consumers
are faci ng.
In the past, a number of economi c studi es have
i dent i f i ed a s mal l but pos i t i ve bi as i n t he
measurement of nati onal consumer pri ce i ndi ces,
suggesti ng that a measured i nf l ati on rate of, say,
smal l er than
1
/
2 percentage poi nt mi ght i n fact be
consistent with true price stability. For the euro
area (i.e. all the EU countries that have adopted the
euro as thei r currency), no preci se esti mates for
such a measurement bi as are avai l abl e. However,
one can expect the si ze of such a possi bl e bi as
to be rather smal l for two reasons. Fi rst, the
Harmonised Index of Consumer Prices (HICP) this
is a harmonised CPI for all euro area countries is
a rel ati vely new concept. Second, Eurostat, the
European Commi ssi on agency responsi bl e for thi s
area of stati sti cs at the EU l evel , has attempted to
avoi d a measurement bi as i n the HI CP by setti ng
appropri ate stati sti cal standards.
Nominal and real variables
As i s expl ai ned above, i n the case of i nf l ati on, a
given amount of money can buy increasingly fewer
goods. This is the same as saying that there is a fall
in the value of money or a decrease in its purchasing
power. Thi s observati on bri ngs us on to another
important economic issue: the difference between
nominal and real variables. A nominal variable is one
that i s measured i n current pri ces. Such vari abl es
usual ly move wi th the pri ce l evel and therefore
wi th i nf l ati on. I n other words, the ef f ects of
i nf l at i on have not been account ed f or. Real
vari abl es, however, such as real i ncome or real
wages, are vari abl es where the effects of i nfl ati on
have been deducted or taken out.
Let us assume that a workers earnings increase by
3 % i n nomi nal (i . e. i n money) terms per year, i n
other words, hi s monthly earni ngs i ncrease f rom,
say, EUR 2000 to EUR 2060. If we further assume
that the general pri ce l evel were to i ncrease
by 1.5 % over the same period, which is equival ent
to sayi ng that the rate of i nfl ati on i s 1. 5 % per
annum, then the i ncrease i n the real wage i s
((103/101. 5) 1) x 100 1. 48 % (or approxi mately
3 % 1. 5 % = 1. 5 %). Therefore, the hi gher the rate
of i nfl ati on for a gi ven nomi nal wage i ncrease, the
fewer goods the worker can buy.
Another important distinction is between nominal
and real i nterest rates (see al so Box 3. 2 bel ow).
By way of an exampl e, l et us suppose that you can
buy a bond wi th a maturi ty of one year at f ace
val ue whi ch pays 4 % at the end of the year. If you
were to pay EUR 100 at the begi nning of the year,
you would get EUR 104 at the end of the year. The
bond therefore pays a nominal interest rate of 4 %.
Note that the i nterest rate refers to the nomi nal
i nterest rate, unl ess otherwi se stated.
Now l et us suppose that the i nfl ati on rate i s agai n
1.5 % for that year. This is equivalent to saying that
today the basket of goods will cost EUR100, and next
year it will cost EUR 101.50. If you buy a bond with a
4 % nominal interest rate for EUR 100, sell it after
a year and get EUR 104, then buy a basket of goods
for EUR 101.50, you will have EUR 2.50 left over. So,
after factoring in inflation, your EUR 100 bond will
3
S TABI LI TY
THE I MPORTANCE OF PRI CE
Economists call the interest rate that the bank (or
a normal bond) pays the nominal interest rate. The
real i nterest rate i s defi ned as the i ncrease i n the
purchasing power achieved with this investment. If i
denotes the nominal interest rate, r the real interest
rate and p the rate of inflation, then the relationship
between these three vari abl es can be wri tten as:
7
r = i p
Following on from this, the real interest rate is the
difference between the nominal interest rate and the
rate of i nfl ati on. By rearrangi ng thi s equati on, i t i s
easy to see that the nominal interest rate equals the
sum of the real interest rate and the inflation rate:
i = r + p
So, what would this equation tell us about
the determinants of nominal interest rates?
When a borrower (for exampl e a person who
wants to buy a new car) and a l ender (for exampl e
a bank) agree on a nomi nal i nterest rate, they do
not know exactly what the inflation rate will be for
t he l oan peri od. I t i s t heref ore i mpor t ant t o
di sti ngui sh between two concepts of the real
interest rate: the real interest rate the borrower and
l ender expect when the l oan i s made, cal l ed the ex
ante real (r
*
) interest rate, and the real interest rate
actually realised, called the ex post interest rate (r).
Al though borrowers and l enders cannot predi ct
future inflation accurately, it seems quite plausible
that they do have some expectati on of the future
inflation rate. Let p denote actual realised inflation
and p
e
the expectation of this rate of inflation. The
ex ante real interest rate is i p
e
, and the ex post
real i nterest rate i p. The two i nterest rates
di ffer when actual or realised inflation differs from
expected inflation. Clearly the nominal interest rate
cannot take account of f uture real i sed i nf l ati on
because this is not known when the nominal interest
rate is set. The nominal interest rate can only take
i nto account expected i nf l ati on.
i = r
*
+ p
e
Expressed i n thi s way, the equati on i s cal l ed the
Fi sher equati on, af ter economi st I rvi ng Fi sher
(18671947). I t basi cal ly shows that the nomi nal
i nterest rate can change for two reasons, namely
because the expected real interest rate (r
*
) changes
or because the expected inflation rate (p
e
) changes.
More precisely, the equation postulates that, given
the ex ante real rate, the nomi nal i nterest rate i
moves in parallel with changes in expected inflation
p
e
. Thi s one-for-one rel ati onshi p between the
expected i nf l ati on rate and the nomi nal i nterest
rate i s cal l ed the Fi sher effect, i . e. where hi gher
i nf l ati on l eads to hi gher nomi nal i nterest rates.
A hi gh nomi nal i nterest rate on a bank deposi t or
government bond may therefore simply reflect high
inflation expectations and does not necessarily signal
that the real return on this investment is expected
to be hi gh as wel l . Thi s concept i s i mportant for
everyone who borrows or l ends money.
I t shoul d al so be not ed t hat , under cer t ai n
circumstances, interest rates can include risk premia.
These usual ly encompass i nf l ati on (uncertai nty)
ri sk premia, exchange rate ri sk premia and defaul t
ri sk premi a.
BOX 3. 2: THE RELATI ONS HI P BETWEEN EXPECTED I NFLATI ON AND I NTEREST RATES
THE SO- CALLED FI SHER EF FECT
7 Note that this relationship
is just an approximation,
which is only reasonably
accurate as long as r, i and
p are relatively small.
In fact, it can be
demonstrated that
1 + r = (1 + i) x (1 + p)
or r = i p r x p. Of
course, for low levels of
r and p, the term r x p
becomes negligible and,
therefore, r = i p is the
approximation used.
28
29
earn you about EUR 2. 50 i n real i ncome, whi ch
i s equi val ent to saying that the real interest rate is
about 2.5 %. It is obvious that if inflation is positive
then the real interest rate is lower than the nominal
i nterest rate.
THE BENEFI TS
OF PRI CE STABI LI TY
Price stability supports higher
living standards by helping to
The i nformati on above expl ai ns why i nfl ati on and
def l ati on are general ly undesi rabl e phenomena.
I ndeed, there are substanti al di sadvantages and
costs related to inflation and deflation. Price stability
prevents these costs from arising and brings about
important benefits for all citizens. There are several
ways in which pri ce stabi l i ty hel ps to achi eve hi gh
levels of economic welfare, e. g. in the form of high
empl oyment.
reduce uncertainty about general
price developments and thereby improve
the transparency of relative prices
Fi rst, pri ce stabi l i ty makes i t easi er for peopl e to
i denti f y changes i n the pri ces of goods expressed
in terms of other goods (i.e. relative prices), since
such changes are not conceal ed by fl uctuati ons i n
the overall price level. For example, let us suppose
that the pri ce of a certai n product i ncreases by
3 %. If the general pri ce l evel i s stabl e, consumers
know that the rel ati ve pri ce of thi s product has
i ncreased and may therefore deci de to buy l ess of
i t. If there i s hi gh and unstabl e i nfl ati on, however,
i t i s more di ffi cul t to fi nd out the rel ati ve pri ce,
whi ch may have even decl i ned. I n such a si tuati on
it may be better for the consumer to buy relatively
more of the product of whi ch the pri ce has
i ncreased by only 3 %.
In the case of general deflation, consumers may not
be aware of the fact that a fall in the price level of
a si ngl e product merel y ref l ects general pri ce
devel opments and not a f al l i n the rel ati ve pri ce
l evel of thi s good. As a result, they may mi stakenly
buy too much of thi s product.
Consequent l y, i f pri ces are st abl e, f i rms and
consumers do not run the ri sk of mi si nterpreti ng
changes i n the general pri ce l evel as rel ati ve pri ce
changes and can make better informed consumption
and i nvestment deci si ons.
Uncertainty about the rate of inflation may also lead
f i rms to make wrong empl oyment deci si ons. To
illustrate this, let us suppose that in an environment
of hi gh i nfl ati on, a fi rm mi si nterprets the i ncrease
i n the market pri ce of i ts goods by, say, 5 %, as a
rel ati ve pri ce decrease as i t i s not aware that the
inflation rate has recently fallen from, say, 6 % to 4 %.
The f i rm mi ght then deci de to i nvest l ess and l ay
of f workers i n order to reduce i ts producti on
capacities, as it would otherwise expect to make a
l oss gi ven the percei ved decrease i n the rel ati ve
pri ce of i ts goods. However, thi s deci si on woul d
ul ti mately turn out to be wrong, as the nomi nal
wages of empl oyees due to l ower i nfl ati on may
i ncrease by l ess than that assumed by the f i rm.
Economists would describe this as a misallocation
of resources. In essence, i t i mpl i es that resources
(capi tal , l abour, etc. ) have been wasted, as some
empl oyees woul d have been made redundant
because of i nstabi l i ti es i n pri ce devel opments.
3.3
3
Price stability makes it
easier for people to identify
changes in the prices of
goods.
S TABI LI TY
30
A similar waste of resources would result if workers
and unions were uncertain about future inflation and
therefore demanded a rather hi gh nomi nal wage
i ncrease i n order to avoi d hi gh f uture i nf l ati on
leading to significant declines in real wages. If firms
had l ower i nfl ati on expectati ons than workers/
unions in such a situation, they would consider a given
nomi nal wage i ncrease as a rather hi gh real wage
increase and may therefore reduce their workforce
or, at l east, hi re fewer workers than they woul d
wi thout the hi gh percei ved real wage i ncrease.
Pri ce stabi l i ty reduces i nfl ati on uncertai nty and
therefore hel ps to prevent the mi sal l ocati on of
resources descri bed above. By hel pi ng the market
gui de resources to where they can be used most
producti vely, l asti ng pri ce stabi l i ty i ncreases the
ef f i ci ency of the economy and, theref ore, the
wel f are of househol ds.
reduce inflation risk premia in
interest rates
Second, i f credi tors can be sure that pri ces wi l l
remai n stabl e i n the future, they wi l l not demand
an ext r a ret ur n ( a s o- cal l ed i nf l at i on r i s k
premi um) to compensate them for the i nf l ati on
ri sks associ ated wi th hol di ng nomi nal assets over
the l onger term (see Box 3. 2 for detai l s). By
reduci ng such ri sk premi a, thereby bri ngi ng about
l ower nomi nal i nt erest rat es, pri ce st abi l i t y
contributes to the efficiency with which the capital
markets allocate resources and therefore increases
the i ncenti ves to i nvest. Thi s agai n fosters j ob
creati on and, more general ly, economi c wel f are.
avoid unnecessary hedging activities
Thi rd, the credi bl e mai ntenance of pri ce stabi l i ty
also makes it less likely that individuals and firms will
divert resources from productive uses in order to
protect themselves (i.e. to hedge) against inflation
or def l ati on, for exampl e by i ndexi ng nomi nal
contracts to price developments. As full indexation
i s not possi bl e or i s too costly, i n a hi gh-i nf l ati on
environment there is an incentive to stockpile real
goods, si nce i n such ci rcumstances they retai n
thei r val ue better than money or certai n fi nanci al
assets. However, an excessi ve stockpiling of goods
i s cl early not an effi ci ent i nvestment deci si on and
hi nders economi c and real i ncome growth.
reduce distortionary effects of tax
systems and social security systems
Four t h, t ax and wel f are syst ems can creat e
i ncenti ves whi ch di stort economi c behavi our. I n
many cases, these di storti ons are exacerbated by
i nf l ati on or def l ati on, as fi scal systems do not
normal ly al l ow for the i ndexati on of tax rates and
soci al securi ty contri buti ons to the i nfl ati on rate.
For i nstance, sal ary i ncreases that are meant to
compensate workers for inflationary developments
could result in employees being subject to a higher
tax rate, a phenomenon that i s known as col d
progres s i on. Pr i ce s t abi l i t y reduces t hes e
distortionary effects associated with the impact of
i nf l ati onar y or def l ati onar y devel opments on
taxati on and soci al systems.
THE I MPORTANCE OF PRI CE
Lasting price stability
increases the efficiency of
the economy and, therefore,
the welfare of households.
31
3
S TABI LI TY
A situation in which the rate of inflation is very high
and/or rises constantly and eventually becomes out
of control i s cal l ed hyperi nf l ati on. Soci al l y,
hyperi nf l ati on i s a very destructi ve phenomenon
which has far-reaching consequences for individuals
and soci ety as a whol e. Al though there i s no
generally accepted definition of hyperinflation, most
economists would agree that a situation where the
mont hl y i nf l at i on rat e exceeds 50 % can be
descri bed as hyperi nfl ati on.
Hyperi nf l ati on and peri ods of very hi gh i nfl ati on
occurred several ti mes duri ng the 20th century.
Bel ow are some exampl es of count ri es t hat
experienced such high annual rates of inflation and
the respecti ve f i gures for the years i ndi cated:
1922 Germany 5,000 %
1985 Bolivia more than 10,000 %
1989 Argentina 3,100 %
1990 Peru 7,500 %
1993 Brazil 2,100 %
1993 Ukraine 5,000 %
Let us briefly illustrate the consequences of such a
phenomenon. An i nfl ati on rate of 50 % per month
i mpl i es an i ncrease of more than 100-fol d i n the
price level over a year and an increase of more than
two mi l l i on-fol d over three years. There i s no
doubt that such rates of i nf l ati on pl ace a heavy
burden on soci et y. I n f act , i n Germany, t he
hyperinflation that followed World War I and peaked
i n 1923 had devastati ng economi c, soci al and as
i s wi dely agreed pol i ti cal consequences.
As many peopl e l ost thei r savi ngs, thi s l ed to a
substantial loss in wealth for broad segments of the
popul ati on. The real i sati on that pri ce l evel s were
constantly ri si ng sparked a vi ci ous ci rcl e. Peopl e
naturally asked for higher wages, anticipating higher
pri ce l evel s i n the f uture. These expectati ons
became a real i ty, si nce hi gher wages transl ated
into higher costs of production, which again meant
hi gher pri ces. I n the same vei n, peopl e started to
pass on thei r money whi ch l ost i ts val ue by
spendi ng faster and f aster.
The Government reacted to the decline in the value
of money by addi ng more and more zeros to the
paper currency, but over time it became impossible
to keep up with the exploding price level. Eventually
these hyperinflation costs became intolerable. Over
ti me money compl etely l ost i ts rol e as a store of
val ue, uni t of account and medi um of exchange.
Barter became more common and unofficial monies,
such as ci garettes, whi ch di d not l ose thei r val ue
due to i nf l ati on, started to repl ace off i ci al paper
money.
BOX 3. 3: HYPERI NF LATI ON
32
BOX 3. 4: DEMAND FOR CASH
Due to i ts l i qui di ty, money provi des a servi ce to i ts hol der i n the form of maki ng transacti ons easi er.
Otherwi se, peopl e woul d not obvi ously have an i ncenti ve to hol d money whi ch i s not remunerated. By
holding cash, people are subject to so-called opportunity costs, as alternative assets pay a positive rate
of interest which they would miss out on. Therefore, a higher level of expected inflation, and therefore a
hi gher nomi nal i nterest rate (see Box 3. 2), tend to have a negati ve i mpact on the demand for money.
Consider a situation whereby the short-term market interest rate paid on bank deposits or a government
bond is just 2 %. In such a case, holding EUR 1000 in banknotes implies that EUR 20 per year is lost. The
i nterest rate on al ternati ve i nvestment opportuni ti es i s the opportuni ty cost of hol di ng banknotes.
Now let us assume that, because of higher inflation, nominal interest rates increase and you receive 10 %
interest on your bank account instead of 2 %. If you still held EUR 1000 in cash, your opportunity costs would
be EUR 100 per year or around EUR 2 per week. In this case you may decide to reduce your money holding
by, say, EUR 500 and therefore increase your interest income by around EUR 1 per week or EUR 50 per
year. In other words, the higher the interest rate, the lower the demand for banknotes. Economists say the
demand for money i s i nterest el asti c.
increase the benefits of holding cash
Fi fth, i nfl ati on can be i nterpreted as a hi dden tax
on hol di ng cash. In other words, peopl e who hol d
cash (or deposi ts whi ch are not remunerated at
market rates) experi ence a decl i ne i n thei r real
money bal ances and thus i n thei r real f i nanci al
weal th when the pri ce l evel ri ses, j ust as i f part of
their money had been taxed away. So, the higher the
expected rate of inflation (and therefore the higher
nomi nal i nterest rates see Box 3. 2), the l ower
the demand by households for cash holdings (Box 3.4
shows why hi gher nomi nal i nterest rates i mply a
reducti on i n the demand for (non-remunerated)
money). Thi s happens even i f i nf l ati on i s not
uncertai n, i . e. i f i t i s ful ly expected. Consequently,
i f peopl e hol d a l ower amount of cash, they must
make more frequent visits to the bank to withdraw
money. These i nconveni ences and costs caused by
reduced cash hol di ngs are of ten metaphori cal ly
descri bed as the shoe-l eather costs of i nfl ati on,
because walking to the bank causes ones shoes to
wear out more quickly. More generally, reduced cash
holdings can be said to generate higher transaction
costs.
THE I MPORTANCE OF PRI CE
33
prevent the arbitrary distribution of
wealth and income
Si xth, mai ntai ni ng pri ce stabi l i ty prevents the
considerable economic, social and political problems
rel ated to the arbi trary redi stri buti on of weal th
and income witnessed during times of inflation and
deflation. This holds true in particular if changes in
the pri ce l evel are di f fi cul t to anti ci pate, and for
groups i n soci ety who have probl ems protecti ng
their nominal claims against inflation. For instance,
i f there i s an unexpected i ncrease i n i nf l ati on,
everyone wi th nomi nal cl ai ms, for exampl e i n the
form of longer-term wage contracts, bank deposits
or government bonds, experi ences l osses i n the
real value of these claims. Wealth is then transferred
in an arbitrary manner from lenders (or savers) to
borrowers because the money i n whi ch a l oan i s
ul ti matel y repai d buys f ewer goods than was
expected when the l oan was made.
Should there be unexpected deflation, people who
hol d nomi nal cl ai ms may stand to gai n as the real
value of their claims (e. g. wages, deposits) increases.
However, i n ti mes of def l ati on, borrowers or
debtors are often unable to pay back their debt and
may even go bankrupt. This could damage society as
a whol e, and i n parti cul ar those peopl e who hol d
claims on, and those who work for, firms that have
gone bankrupt.
Typically, the poorest groups of society often suffer
the most f rom i nf l ati on or def l ati on, as they have
only limited possibilities to hedge against it. Stable
pri ces thus hel p to mai ntai n soci al cohesi on and
st abi l i t y. As demonst rat ed at cer t ai n poi nt s
throughout the 20th century, high rates of inflation
often create social and political instability as those
groups who l ose out because of i nf l ati on feel
cheated i f (unexpected) i nf l ati on taxes away a
l arge part of thei r savi ngs.
contribute to financial stability
Seventh, sudden reval uati ons of assets due to
unexpected changes in inflation can undermine the
soundness of a banks balance sheet. For instance, let
us assume that a bank provi des l ong-term fi xed
interest loans which are financed by short-term time
deposi ts. I f there i s an unexpected shi f t to hi gh
i nf l ati on, thi s wi l l i mply a f al l i n the real val ue of
assets. Fol l owi ng thi s, the bank may f ace sol vency
problems that could cause adverse chain effects.
I f monet ar y pol i cy mai nt ai ns pri ce st abi l i t y,
i nf l ati onary or def l ati onary shocks to the real
val ue of nomi nal assets are avoi ded and fi nanci al
stabi l i ty i s therefore al so enhanced.
By maintaining price stability, central banks
contribute to broader economic goals
Al l of these arguments suggest that a central bank
that maintains price stability contributes substantially
to the achi evement of broader economi c goal s,
such as hi gher standards of l i vi ng, hi gh and more
stable levels of economic activity and employment.
Thi s concl us i on i s s uppor t ed by economi c
evi dence whi ch, for a wi de vari ety of countri es,
methodol ogi es and peri ods, demonstrates that i n
the long run, economies with lower inflation appear
on average to grow more rapi dly i n real terms.
3
In the long run, economies
with lower inflation appear,
on average, to grow more
rapidly in real terms.
S TABI LI TY
FACTORS DETERMI NI NG
PRI CE DEVELOPMENTS
This chapter provides detailed information to
help answer questions such as what determines
the general price level or what the factors are
that drive inflation, how the central bank, or
more precisely monetary policy, is able to
ensure price stability, what the role of fiscal
policy is, and whether monetary policy should
focus directly on enhancing real growth or
reducing unemployment, or in other words,
what monetary policy can and cannot achieve.
provides a brief overview of what
monetary policy can and cannot do.
deals with the question of how monetary
policy can influence interest rates.
illustrates the effects of interest rate
changes on expenditure decisions
taken by households and firms.
reviews the factors driving price
developments over shorter-term
horizons.
looks at the factors driving price
developments over medium to longer-
term horizons, and explains that over such
horizons monetary policy has the appropriate
instruments to influence prices. It is therefore
responsible for trends in inflation.
4.1
4.2
4.3
4.4
4.5
4
WHAT MONETARY POLI CY CAN
AND CANNOT DO AN OVERVI EW
How can monetary policy influence the price level?
Thi s questi on touches upon what economi sts
general ly descri be as the so-cal l ed transmi ssi on
process, i.e. the process through which actions of
the central bank are transmi tted through the
economy and, ul ti matel y, to pri ces. Whi l e thi s
process i s i n essence extremely compl ex one
that changes over ti me and i s di f ferent i n vari ous
economies, so much so that, even today, not all the
details behind it are fully known its basic features
are wel l understood. The way i n whi ch monetary
pol i cy exerts i ts i nfl uence on the economy can be
expl ai ned as fol l ows: the central bank i s the sol e
issuer of banknotes and bank reserves, i.e. it is the
monopol i sti c suppl i er of the so-cal l ed monetary
base. By virtue of this monopoly, the central bank
i s abl e to i nfl uence money market condi ti ons and
steer short-term i nterest rates.
In the short run, the central bank can
influence real economic developments
I n the short run, a change i n money market (i . e.
short-term) i nterest rates i nduced by the central
bank sets a number of mechani sms i n moti on,
mai nly because thi s change has an i mpact on the
spending and saving decisions taken by households
and f i rms. For exampl e, hi gher i nterest rates wi l l ,
al l thi ngs bei ng equal , make i t l ess attracti ve for
households and firms to take out loans in order to
finance their consumption or investment. They also
make i t more attracti ve for househol ds to save
thei r current i ncome rather than spend i t. Fi nal ly,
changes in official interest rates may also affect the
supply of credi t. These devel opments, i n turn, and
wi th some del ay, i nf l uence devel opments i n real
economi c vari abl es such as output.
In the long run, changes in the money sup-
ply will affect the general price level
The dynami c processes outl i ned above i nvol ve a
number of different mechanisms and actions taken
by various economic agents at different stages of the
process. Furthermore, the size and strength of the
various effects can vary according to the state of the
economy. As a result, monetary policy usually takes
a consi derabl e amount of ti me to af fect pri ce
devel opment s . However, i n t he economi cs
profession, it is widely accepted that, in the long run,
i.e. af ter al l adj ustments i n the economy have
4.1
2 1 3 5 4
4.1 What monetary policy can and cannot do an overview
4.2 Money and interest rates how can monetary policy influence interest rates?
4.3 How do changes in interest rates affect the expenditure decisions taken by consumers and firms?
4.4 Factors driving price developments over shorter-term horizons
4.5 Factors driving price developments over longer-term horizons
36
FACTORS DET ERMI NI NG PRI CE
worked through, a change i n the quanti ty of
money supplied by the central bank (all things being
equal) will only be reflected in a change in the
general l evel of pr i ces and wi l l not caus e
permanent changes i n real variables such as real
output or unemployment. A change i n the quanti ty
of money i n ci rcul ati on brought about by the
central bank is ultimately equivalent to a change in
the uni t of account (and thereby i n the general
price level), which leaves all other variables stable,
in much the same way as changing the standard unit
used to measure di stance (e. g. swi tchi ng from
ki l ometres to mi l es) woul d not al ter the actual
di stance between two l ocati ons.
but not the level of real income
or employment
This general principle, referred to as the long-run
neut ral i t y of money, underl i es al l st andard
macroeconomi c t hi nki ng and t heoret i cal
f rameworks. As menti oned above, a monetary
pol i cy whi ch credi bly mai ntai ns pri ce stabi l i ty has
a si gni f i cant posi ti ve i mpact on wel f are and real
acti vi ty. Beyond thi s posi ti ve i mpact of pri ce
stability, real income or the level of employment in
the economy are, i n the l ong run, essenti al l y
determi ned by real (suppl y-si de) f actors, and
cannot be enhanced by expansi onary monetary
pol i cy.
8
These mai n determi nants of l ong-run empl oyment
and real income are technology, population growth
and all aspects of the institutional framework of the
economy (notably property rights, tax policy, welfare
pol i ci es and other regul ati ons determi ni ng the
flexibility of markets and incentives to supply labour
and capi tal and to i nvest i n human resources).
Inflation is ultimately a monetary
phenomenon
I nf l ati on i s ul ti mately a monetary phenomenon.
As conf i rmed by a number of empi ri cal studi es,
prol onged peri ods of hi gh i nf l ati on are typi cal ly
associ ated wi th hi gh monetary growth (see the
char t bel ow) . Whi l e ot her f act or s ( s uch as
vari ati ons i n aggregate demand, technol ogi cal
changes or commodity price shocks) can influence
pri ce devel opments over shorter hori zons, over
ti me thei r effects can be offset by some degree of
adj ustment of monetary pol i cy. I n thi s sense, the
l onger-term trends of pri ces or i nf l ati on can be
control l ed by central banks.
37
4
A monetary policy which
credibly maintains price
stability has an important
positive impact on welfare.
8 Supply-side factors are factors driving the supply of goods and
services in an economy, in particular the amount and quality of
capital and labour, as well as technological progress and the
design of structural policies.
20
40
60
80
100
20 40 60 80
45
0 100
Average annual rates
of growth in M2 and in
consumer prices from
196090 in 110 countries.
Source: McCandless and Weber (1995)
CHART MONEY AND I NFLATI ON
DEV EL OPMENT S
Inflation (%)
Money growth (%)
38
In this short overview a number of points have been
addressed whi ch may requi re further expl anati on.
As inflation is ultimately a monetary phenomenon,
it seems necessary to explain in greater detail how
monetary policy affects the economy and, ultimately,
price developments. This is best addressed in three
steps.
Fi rst, i n Secti on 4. 2, we di scuss why and how
monetary policy can influence interest rates. Second,
in Section 4.3 we consider how changes in interest
rates can affect expendi ture deci si ons taken by
consumers and f i rms. Fi nal l y, we anal yse how
these changes i n aggregate demand af fect pri ce
developments. In this context we also discuss other,
i . e. non-monetary or real factors whi ch can affect
pri ce devel opments over the shorter term. It may
be usef ul to understand the overal l or aggregate
supply and demand for goods i n an economy (see
Box 4. 2) and to di sti ngui sh between short and
l ong-run ef fects (Secti ons 4. 4 and 4. 5).
MONEY AND I NTEREST RATES
HOW CAN MONETARY POLI CY
I NFLUENCE I NTEREST RATES ?
A central bank can determi ne the short-term
nomi nal i nterest rates whi ch banks have to pay
when they want to get credit from the central bank.
Banks need to go to the central bank for credi t as
they need banknotes for their clients and need to
fulfil minimum reserve requirements in the form of
deposi ts wi th the central bank.
As central banks are the only institutions which can
i ssue banknotes (and bank reserves), i . e. they are
the monopolistic suppliers of base money, they can
determi ne the pol i cy rates, e. g. the short-term
nominal interest rates on loans given to the banks.
The expectations regarding the future development
of pol i cy rates i n turn i nf l uence a wi de range of
l onger-term bank and market i nterest rates.
HOW DO CHANGES I N I NTEREST RATES
AFF ECT THE EXPENDI TURE DECI SI ONS
TAKEN BY CONS UMERS AND FI RMS?
From the perspective of an individual household, a
higher real interest rate makes it more attractive to
save, si nce the return on savi ng i n terms of future
consumption is higher. Therefore, higher real interest
rates typically lead to a fall in current consumption
and an increase in savings. From a firms standpoint,
a hi gher real i nterest rate wi l l , provi ded al l other
vari abl es remai n the same, deter i nvestment,
because fewer of the available investment projects
will offer a return sufficient to cover the higher cost
of capi tal .
To sum up, an i nterest rate ri se wi l l make current
consumpti on l ess desi rabl e for househol ds and
discourage current investment by firms. The effects
on i ndi vi dual househol ds and f i rms show that an
i ncrease i n real i nterest rates brought about by
monetary policy will lead to a reduction in current
expendi ture i n the economy as a whol e (i f the
other vari abl es remai n constant). Economi sts say
t hat such a pol i cy change causes a drop i n
aggregate demand and i s thus often referred to as
a ti ghteni ng of monetary pol i cy.
I t i s i mportant to understand that there are ti me
lags in this process. It might easily take months for
f i rms to put a new i nvestment pl an i n pl ace;
i nvestments i nvol vi ng the constructi on of new
pl ants or the orderi ng of speci al equi pment can
4.2
4.3
FACTORS DET ERMI NI NG PRI CE
39
even take years. Housi ng i nvestment al so takes
some time to respond to changes in interest rates.
Also many consumers will not immediately change
their consumption plans in response to changes in
i nterest rates. Indeed, i t i s general ly agreed that
the overall transmission process of monetary policy
takes ti me. Monetary pol i cy cannot, therefore,
control the overall demand for goods and services
in the short run. Expressed in another way, there is
a significant time lag between a change in monetary
pol i cy and i ts ef fect on the economy.
4
DEV EL OPMENT S
As explained in more detail in Box 3.2, the ex ante
real interest rate is the real return which a certain
financial asset is expected to deliver. It is defined as
the nomi nal i nterest rate mi nus expected i nfl ation
over the maturity for which the interest rate is fixed.
The i mpact of monetary pol i cy on short-term real
i nterest rates i s rel ated to two i ssues: monetary
pol i cy control s the short-term nomi nal i nterest
rate, and pri ces are sti cky i n the short run.
What i s the meani ng of sti cky pri ces? Empi ri cal
evidence tells us that most prices are fixed for some
ti me; very often fi rms do not i nstantly adj ust the
prices they charge in response to changes in supply
or demand. In reality, some prices are adjusted very
often (e. g. petrol pri ces), whi l e other pri ces are
adj usted only every month or once a year. There
can be vari ous reasons for thi s. Fi rst, pri ces are
someti mes set by l ong-term contracts between
fi rms and customers to reduce the uncertai nti es
and costs associ ated wi th frequent negoti ati ons.
Second, fi rms may hol d pri ces steady i n order not
to annoy thei r regul ar customers wi th f requent
price changes. Third, some prices are sticky because
of the way markets are structured; once a firm has
pri nted and di stri buted a catal ogue or pri ce l i st,
it is costly to alter prices. Finally, the calculation of
new pri ces i s costl y as wel l . I n the l ong run,
however, pri ces adj ust to new supply and demand
conditions. Put another way, prices are fully flexible
i n the l ong run.
9
Now assume that the central bank i ncreases the
supply of money. For example, it prints new money
and buys government bonds. Peopl e are onl y
prepared to hol d a hi gher amount of money and
reduce their holdings of bonds if the return on the
bonds, i.e. the interest rate, falls. Thus, if the central
bank i ncreases the supply of money, the nomi nal
interest rate must fall in order to induce people to
hol d a hi gher amount of money. And as pri ces are
sticky in the short run, this implies that short-term
i nf l ati on expectati ons remai n l argely unchanged.
As a consequence, a change in short-term nominal
interest rates translates into a change in the ex ante
expected real i nterest rate (see al so Box 3. 2).
Therefore, monetary policy can influence expected
or ex ante real i nterest rates on short-term
i nstruments.
9 With the exception of administered prices, which can only be
expected to change very rarely.
BOX 4. 1 WHY CAN CENTRAL BANKS I NF LUENCE ( EX ANTE) REAL I NTEREST RATES ?
THE ROLE OF STI CKY PRI CES
FACTORS DET ERMI NI NG PRI CE
40
An easy way of illustrating how changes in aggregate
demand affect price developments is to use a simple
model focusing on aggregate supply and demand in
the whole economy. For the purposes of this exercise,
we wi l l keep the analysi s fai rly strai ghtforward. At
the same time, we will illustrate our arguments with
charts. The model basically attempts to describe the
relationship between the real quantity of goods and
services supplied and demanded in an economy and
the aggregate pri ce l evel .
Aggregate supply and demand
the short-run equilibrium
The chart below illustrates aggregate supply (AS) and
aggregate demand (AD), with the price level on the
vertical axis and real output on the horizontal axis.
CHART 1 AGGREGATE DEMAND
AND SHORT- RUN AGGREGATE SUPPLY
Aggregate demand and the price level
To understand the sl ope of aggregate demand, we
have to analyse what happens to real expendi ture
decisions when the price level changes, assuming all
other economic variables remain the same. It can be
shown that the aggregate demand curve has a
negati ve sl ope. One way to thi nk about thi s i s i n
terms of suppl y and demand f or real money
balances. If prices are higher but the nominal supply
of money is fixed, people will experience lower real
money balances and this implies that they can only
finance a lower amount of transactions. Conversely,
i f the pri ce l evel i s l ower, real money bal ances are
higher, which in turn allows for a higher volume of
transacti ons, meani ng that there wi l l be a greater
demand for real output.
Aggregate supply and the price level
in the short run
As i ndi cated by i ts name, aggregate supply deal s
with the supply of goods and services produced by
firms. We first need to understand how the overall
l evel of pri ces i s rel ated to the overal l l evel of
output in the short run, i.e. assuming that all other
f actors (producti on technol ogy, nomi nal wages,
etc. ) remai n the same. How does a change i n the
pri ce l evel af fect the real production or the real
output of firms? In essence, i f nomi nal wages are
gi ven, a hi gher pri ce l evel wi l l l ead to a decl i ne i n
real wages. With lower real wages it becomes more
prof i tabl e for f i rms to hi re more workers and to
increase production. In other words, real wages are
a key determi nant of empl oyment.
BOX 4. 2 HOW DO CHANGES I N AGGREGATE DEMAND AFF ECT
ECONOMI C ACTI VI TY AND PRI CE DEVELOPMENTS?
Price level
AS
Real output
AD
DEV EL OPMENT S
41
Wi th hi gher pri ces and al l other factors, such
as producti on technol ogy and nomi nal wages,
remai ni ng unchanged, f i r ms wi l l t hus r ai s e
employment and increase production. The short-run
aggregate supply curve is therefore upward sloping.
The i ntersecti on of the two curves determi nes
what economi st s cal l t he equi l i bri um. The
concept of equilibrium is crucial in economics. This
i s because, i n such a si tuati on, the wi shes of both
market si des coi nci de and, therefore, there i s no
tendency for f urther change. I n thi s case, the
equi l i bri um determi nes the pri ce l evel and the
level of real output prevailing in an economy at the
same ti me.
What happens i f the economy f aces a state of
disequilibrium? Suppose the economy faces a price
l evel whi ch i s hi gher than the equi l i bri um l evel . In
such a si tuati on aggregate supply i s too hi gh and
aggregat e demand t oo l ow compared wi t h
equilibrium. What will happen now? If the price level
i s hi gher than i n equi l i bri um, buyers want to buy
l ess than producers want to sel l . Therefore, some
suppl i ers wi l l l ower thei r pri ces, whi ch i n turn
l eads to an i ncrease i n aggregate demand. At the
same time, the lower prices will raise real wages (as
nominal wages are fixed in the short run) and as
real wages represent a cost factor for firms they
wi l l cut back product i on and tend to l ower
aggregate supply. This process will go on until an
equi l i bri um si tuati on i s reached, i . e. a si tuati on
where the wi shes and pl ans of buyers and sel l ers
coi nci de at a certai n pri ce and output l evel .
Aggregate supply in the long run
Why do we speak above of the short-run supply
curve? The positive impact of a higher price level on
real output wi l l only l ast as l ong as nomi nal and,
theref ore al so real , wages remai n unchanged.
I n real i ty, nomi nal wages are normal ly f i xed for
about one year, and i n some cases for up to two
years. I f workers or uni ons do not accept the
l ower real wages caused by hi gher i nf l ati on they
wi l l use the next wage negoti ati ons to demand
compensati on i n the form of hi gher wages. I f real
wages return to the l evel they were at before the
i ncrease i n the pri ce l evel (and i f producti on
technol ogy i s unchanged), fi rms wi l l no l onger
f i nd i t prof i tabl e to mai ntai n producti on and
empl oyment at the hi gher l evel and wi l l thus
make cuts. I n other words, i f real wages cannot
be reduced by hi gher i nf l ati on i n the l ong run,
empl oyment and product i on wi l l al s o be
independent of price developments in the long run.
Thi s means that the l ong-term aggregate supply
curve wi l l be verti cal .
4
42
FACTORS DET ERMI NI NG PRI CE
The long-run equilibrium
CHART 2 AGGREGATE DEMAND
AND LONG- RUN AGGREGATE SUPPLY
The intersection of the AS curve with the horizontal
axi s (see AS* i n Chart 2) i s what economi sts cal l
the potential level of output. The potential level of
output represents the val ue of f i nal goods and
servi ces produced when the economys resources
are f ul l y empl oyed, gi ven the current state of
technology and structural features of the economy
(such as labour market regulations, welfare and tax
systems, etc. ).
So far we have discussed movements along the
curves, with all other factors but prices and real
output remaining unchanged. We now need to
understand what happens i f these other f actors
change. In essence, such changes shift the curves to
the ri ght or the l eft.
Factors affecting aggregate supply
and aggregate demand
Accordi ng to the si mpl e model we have been
usi ng, the combi nati on of pri ces and real i ncome
that an economy i s experi enci ng i s obvi ousl y
determi ned by the i nterpl ay of aggregate supply
and demand. Thi s rai ses questi ons regardi ng the
f actors l eadi ng to shi f ts i n the two curves.
The factors leading to an increase in aggregate
demand (i.e. a shift in AD outwards or to the right)
i ncl ude an i ncrease i n government expendi ture, a
reducti on i n taxes, a depreci ati on of the home
currency and an increase in real wealth (e. g. higher
stock and land prices), which in turn lead to higher
pri vate consumpti on and i nvestment expendi ture.
Pri vate consumpti on and i nvestment may al so be
dri ven by expectati ons. For exampl e, i f f i rms
expect hi gher f uture prof i ts, they wi l l tend to
i ncreas e i nves t ment expendi t ures . And i f
househol ds expect hi gher real i ncome as a resul t
of hi gher expected l abour producti vi ty, consumer
expendi ture wi l l i ncrease. For thi s reason, an
improvement in consumer and investor confidence
i s normal ly rel ated to an i ncrease i n aggregate
demand.
Wi th regard to the i mpact of monetary pol i cy, we
can observe that an i ncrease i n money supply and
the rel ated l ower real i nterest rates wi l l cause
aggregate demand to i ncrease, thus shi f ti ng the
demand curve to the ri ght.
10
I f these vari abl es
change in the opposite direction, aggregate demand
wi l l fal l (i . e. AD wi l l shi f t to the l ef t).
Price level
AS*
Real output
AD
AS
43
DEV EL OPMENT S
4
11) Economists often express a decline in money demand in terms of an increase in the velocity of money. The latter variable can be defined
as the speed with which money is transferred between different money holders and thus determines how much money is required for a
particular level of transaction. In fact these two phenomena must be regarded as two different sides of the same coin. If people want to
hold less money, the available stock of money will, given a constant money supply, have to change hands more often and so circulate more.
This is equivalent to a higher velocity of money. We will return to this issue in later sections.
Regardi ng aggregat e suppl y, we can see t hat
i ncreases i n the pri ces of producti on factors, such
as wages, or i ncreases i n oi l pri ces wi l l l ead to a
shi f t to the l ef t i n aggregate supply. On the other
hand, t echnol ogi cal progress or i ncreases i n
productivity will shift aggregate supply to the right,
as thi s al l ows for more producti on at the same
cost wi th a gi ven quanti ty of l abour i nput.
This analysis shows that changes in the general price
l evel can be brought about by shi f ts i n ei ther the
supply curve or the demand curve or i n both. For
instance, if all other factors remain stable, a decline
in aggregate supply (i.e. a shift of AS to the left)
will be accompani ed by a short-term fal l i n real
output and an i ncrease i n pri ces, whereas an
increase in demand (i.e. a shift of AD to the right)
wi l l mani f est i tsel f i n hi gher short-term real
acti vi ty and hi gher pri ces.
The l ong-run model i l l ustrates that the behavi our
of aggregate demand i s cruci al i n determi ni ng the
general price level that an economy experiences in the
l ong run. If the aggregate supply curve i s verti cal ,
changes i n aggregate demand wi l l affect pri ces but
not output. If, for i nstance, money supply were to
i ncrease, the aggregate demand curve woul d shi f t
to the ri ght and the economy woul d thus, i n the
l ong run, shi f t to a new equi l i bri um where real
producti on has remai ned the same but pri ces
have ri sen.
CHART 3 SHI F TS I N AGGREGATE DEMAND AND
LONG- RUN AGGREGATE SUPPLY
Inflation was defined as a general, or broadly-based,
i ncrease i n the pri ces of goods and servi ces.
Therefore, a process of inflation can only be brought
about by a continuing increase in aggregate demand
over time. This, in turn, is only possible if monetary
pol i cy accommodates such a devel opment by
keeping interest rates low and money growth high.
10 Economists often express a decline in money demand in terms
of an increase in the velocity of money. The latter variable can
be defined as the speed with which money is transferred
between different money holders and thus determines how
much money is required for a particular level of transaction.
In fact these two phenomena must be regarded as two different
sides of the same coin. If people want to hold less money, the
available stock of money will, given a constant money supply,
have to change hands more often and so circulate more. This is
equivalent to a higher velocity of money. We will return to this
issue in later sections.
Prive level
Real output
AS
AD old
AS*
AD new
44
FACTORS DRI VI NG PRI CE DEVELOPMENTS
OVER SHORTER- TERM HORI ZONS
In the fol l owi ng, we wi l l i nvesti gate some f actors
driving short-term price developments. As explained
in more detail in Box 4.2, inflation (i.e. a sustained
increase in the price level) could be caused in either
one or two ways. Pri ces i n general wi l l ri se i f , on
average, ei ther aggregate demand i ncreases or
supply decreases. To put i t di fferently, i nfl ati onary
pres s ures can res ul t i f t here are changes
(economi sts often speak of shocks i f there are
unexpected changes i n economi c devel opments)
which lead consumers to increase their expenditure
or fi rms to reduce thei r producti on. The f i rst
i nstance, where demand i ncreases, resul ti ng i n
i nf l at i on, i s of t en descri bed as demand- pul l
i nfl ati on i n the economi c l i terature. The second
instance, where costs increase and supply therefore
decreases, thus al so resul ti ng i n i nf l ati on, i s often
l abel l ed as cost-push i nf l ati on. The opposi te
happens, i . e. def l ati onary pressures emerge, i f
aggregat e demand f al l s or aggregat e s uppl y
increases. In general, monetary policy often has to
respond to such devel opments i n order to ensure
price stability. In cases of inflationary pressure, the
central bank would normally increase (real) interest
rates to prevent that pressure from translating into
more persi stent devi ati ons from pri ce stabi l i ty.
Price increases that arise because of an increase in
aggregate demand may result from any individual
factor that increases aggregate demand, but the most
significant of these factors, besides monetary policy
(increases in the money supply), are increases i n
government purchases, depreciation of the exchange
rate and increased demand pressures for domestic
goods f rom the rest of the worl d (exports).
Changes in aggregate demand can also be caused by
i ncreased confi dence. It i s l i kely, for exampl e, that
f i rms wi l l i nvest more i f hi gher prof i ts can be
expected i n the f uture. Changes i n aggregate
demand wi l l normal ly i ncrease the pri ce l evel and,
temporari ly, aggregate producti on (see Box 4. 2).
What preci sel y are t he f act ors l eadi ng t o a
reducti on i n aggregate supply and thus to hi gher
pri ces i n the short run? The mai n sources of
f al l i ng aggregat e s uppl y are decreas es i n
producti vi ty, i ncreases i n producti on costs (for
i nstance, i ncreases i n real wages and i n the pri ces
of raw materials, notably oil), and higher corporate
taxes imposed by governments. If all other factors
remain the same, the higher the cost of production,
the smal l er the amount produced at the same
pri ce.
For a given price level, if wages or the costs of raw
materi al s, such as oi l , ri se, f i rms are forced to
reduce the number of peopl e they empl oy and to
cut producti on. As thi s i s the resul t of supply-si de
effects, the resul ti ng i nfl ati on i s often referred to
as cost-push i nf l ati on.
4.4
FACTORS DET ERMI NI NG PRI CE
45
Vari ous ci rcumstances coul d cause the pri ce of
i nputs to ri se, for i nstance, i f the supply of raw
materials such as oil falls short of expectations, or
i f the worl dwi de demand for raw materi al s ri ses.
Increases in real wages (which are not matched by
increased productivity) will also lead to a decline in
aggregate supply and lower employment. Such wage
i ncreases may resul t from a decl i ne i n the l abour
supply, whi ch i n turn may have been caused by a
government regul ati on whi ch has the effect of
reduci ng the i ncenti ves to work (e. g. hi gher taxes
on l abour i ncome). An i ncrease i n the power of
trade uni ons can al so resul t i n hi gher real wages.
I f the f actors descri bed above work i n the other
di recti on, we wi l l see an i ncrease i n aggregate
supply. For example, an increase in productivity (e. g.
based on new technol ogi es) woul d, al l thi ngs
bei ng equal , l ead to l ower pri ces and hi gher
empl oyment i n the short run as i t becomes more
profi tabl e to hi re l abour at gi ven wages. However,
i f real wages were t o i ncrease i n l i ne wi t h
productivity, employment would remain unchanged.
The role of expected inflation
When f i rms and empl oyees negoti ate wages and
when firms set their prices, they often consider what
the level of inflation may be in the period ahead, for
example, over the following year. Expected inflation
matters for current wage settl ements, as future
pri ce ri ses wi l l reduce the quanti ty of goods and
servi ces that a gi ven nomi nal wage can buy. So, i f
i nf l ati on i s expected to be hi gh, empl oyees mi ght
demand a higher nominal wage increase during wage
negot i at i ons . Fi r ms cos t s i ncreas e i f wage
settl ements are based on these expectati ons and
these costs coul d be passed on to customers i n
the form of hi gher pri ces. A si mi l ar case can be
made for pri ce-setti ng on the part of f i rms. As
many individual prices remain fixed for a particular
peri od (for one month or one year, for exampl e;
see Box 4.1), firms which had planned to publi sh a
new pri ce l i st may i ncrease thei r i ndi vi dual pri ces
wi th i mmedi ate ef fect i f they anti ci pate i ncreases
in the general price level or in wages in the future.
So i f peopl e expect i nf l ati on i n the f uture, thei r
behavi our can al ready cause a ri se i n i nf l ati on
today. Thi s i s another reason why i t i s ver y
important for monetary policy to be credible in its
obj ecti ve of mai ntai ni ng pri ce stabi l i ty i n order
to stabi l i se l onger-term i nf l ati on expectati ons at
l ow l evel s, i n l i ne wi th pri ce stabi l i ty.
Taken together, a variety of factors and shocks can
i nf l uence the pri ce l evel i n the short run. Among
them are developments in aggregate demand and its
vari ous components, i ncl udi ng devel opments i n
f i scal pol i cy. Further changes coul d rel ate to
changes i n i nput pri ces, i n costs and producti vi ty,
i n devel opments i n the exchange rate, and i n the
gl obal economy. Al l these factors coul d affect real
activity and prices over shorter-term horizons. But
what about l onger-term hori zons?
Thi s bri ngs us to another i mportant di sti ncti on i n
economics. Economists generally draw a distinction
between the short run and the l ong run (see al so
Box 4. 2).
4
Increases in the external
demand for export products
could have an impact on
current consumption and
investment.
DEV EL OPMENT S
46
FACTORS DRI VI NG PRI CE DEVELOPMENTS
OVER LONGER- TERM HORI ZONS
What i s the rel ati ve i mportance of these f actors
on inflation over longer-term horizons? Or in other
words: are they al l of equal rel evance as regards
inflationary trends? The answer is clearly no. We
shal l see that monetary pol i cy pl ays a cruci al rol e
here.
As already mentioned in previous paragraphs, there
i s a ti me l ag of about one to three years between
changes i n monetary pol i cy and the i mpact on
pri ces. Thi s i mpl i es that monetary pol i cy cannot
prevent unexpected real economi c devel opments
or shocks from havi ng some short-run i mpact on
i nfl ati on. However, there i s wi despread agreement
among economi st s t hat monet ar y pol i cy can
control pri ce devel opments over the l onger term
and therefore al so the trend of i nfl ati on, i . e. the
change i n the pri ce l evel when the economy has
ful ly i ncorporated short-term di sturbances.
In the long run, prices are flexible and can respond
fully to changes in supply and demand. However, in
the short run many individual prices are sticky and
wi l l remai n at thei r current l evel s for some ti me
(see Box 4. 1).
How does thi s di sti ncti on i nf l uence our resul ts?
Wi thout goi ng i nto too much detai l , i t can be
argued that output does not depend on the pri ce
l evel i n the l ong run. It i s determi ned by the gi ven
stock of capital; by the labour force available and the
qual i ty of that l abour force; by structural pol i ci es
which influence incentives to work and to invest; and
by any technol ogi cal devel opments i n the fi el d of
producti on. In other words, the l ong-term l evel of
output depends on a number of real or supply-side
factors. These factors determine the exact position
of the aggregate supply curve.
The other curve that determi nes the state of
equilibrium of the economy is the aggregate demand
curve. As we have seen, a number of f actors can
l ead to i ncreases i n aggregate demand. Among
them are increases in government expenditures, in
external demand for exports, and i n i mproved
expectati ons of future producti vi ty devel opments
which might have an impact on current consumption
and i nvest ment . I t i s obvi ous, however, t hat
al though many of these f actors can i ncrease even
for a protracted period, a sustained increase in the
general pri ce l evel can, i n the l ong run, only be
dri ven by a sustai ned and ongoi ng expansi onary
monetary policy. This point is often made in terms
of the f amous statement accordi ng to whi ch
i nf l ati on i s always and everywhere a monetary
phenomenon. I ndeed, a number of empi ri cal
studi es have provi ded evi dence i n f avour of thi s
hypothesis. The ultimate reason for an inflationary
process in the longer run is, therefore, a sustained
i ncrease i n money supply whi ch i s equi val ent to a
sustai ned expansi onary monetary pol i cy.
4.5
FACTORS DET ERMI NI NG PRI CE
4
47
BOX 4. 3 THE QUANTI TY THEORY OF MONEY
According to an identity which is widely known as
the quanti ty equati on, the change i n the money
stock (M) i n an economy equal s the change i n
nominal transactions (approximated by the change
i n real acti vi ty (YR) pl us the change i n the pri ce
level (P)), minus the change in velocity (V). The
l atter vari abl e can be defi ned as the speed wi th
whi ch money i s transferred between di f ferent
money hol ders and thus determi nes how much
money i s requi red to serve a parti cul ar l evel of
nomi nal transacti ons.
11
I n short:
M = YR + P
Thi s rel ati onshi p i s a so-cal l ed i denti ty, i . e. a
rel ati onshi p that can obvi ously not be fal si f i ed. It
therefore does not provi de any statements about
causality. A sense of causality can only be inferred if
further assumptions regarding the determinants of
the vari abl es are taken i nto account. In parti cul ar,
the fol l owi ng two assumpti ons al l ow the quanti ty
equati on to be transformed i nto the quanti ty
theory. First, output can, in the long run, be regarded
as bei ng determi ned by real -si de f actors l i ke the
productive opportunities of the community and its
tastes and preferences. Second, i n the l ong run,
velocity is regarded as being determined by payment
practices, financial and economic arrangements for
ef fecti ng transacti ons and costs of and returns
from holding money instead of other assets. It then
fol l ows that the quanti ty of money supply whi ch
i s determi ned by the deci si ons taken by the
monetary authorities is, in the long run, linked to
the pri ce l evel . Put another way, over l onger-
term horizons, the price level is determined directly
by changes i n the quanti ty of money and i t moves
proporti onal ly to the l atter.
One implication of this is that the institution which
determines the supply of money, namely the central
bank, i s ul ti mately responsi bl e for l onger-term
trends i n i nf l ati on.
11 This reflects the fact that the left-hand side of the equation
sums up the amount of money used, whereas the right-hand
side reflects the value of the transaction.
I n a l onger-term perspecti ve, monetary pol i cy
actions thus determine whether inflation is allowed
to rise or is kept low. In other words, a central bank
that controls the money supply and the short-term
interest rate has ultimate control over the rate of
i nfl ati on over l onger-term hori zons. If the central
bank keeps short-term i nterest rates too l ow and
increases the money supply by too much, the price
level will ultimately also increase. This basic result
is illustrated by the fundamental economic concept
whi ch addresses i n more detai l the rel ati onshi p
between money and pri ces, namely the quanti ty
theory of money (see Box 4. 3 bel ow).
DEV EL OPMENT S
THE ECB S MONETARY POLI CY
This chapter provides detailed information
to help answer questions such as how EMU
came about, which body is responsible for the
single monetary policy in the euro area, what
the primary objective of the Eurosystem is,
and how it tries to achieve its mandate.
gives a short
historical overview.
elaborates on the
institutional framework.
focuses on the ECBs
monetary policy strategy.
sheds some light on the Eurosystems
operational framework.
5.1
5.2
5.3
5.4
5
A SHORT HI STORI CAL
OVERVI EW
History the three stages
of Economic and Monetary Union
The i dea that Europe shoul d have a si ngl e, uni fi ed
and stabl e monetary system has i ts roots far back
i n hi story (see Box 5. 1). After one unsuccessf ul
attempt in the early 1970s, a decisive impetus to the
integration process came about in June 1988, when
the European Council reconfirmed the objective to
gradual ly achi eve economi c and monetary uni on.
A commi ttee chai red by Jacques Del ors, the then
President of the European Commission, was set up
to study and propose concrete stages leading to this
union. The committees report (the so-called Delors
Report), presented i n Apri l 1989, proposed the
i ntroducti on of an Economi c and Monetary Uni on
(EMU) i n three di screte but evol uti onary steps.
Stage One of EMU
Following the Delors Report, the European Council,
i n June 1989, deci ded that the f i rst stage of EMU
should be launched on 1 July 1990. At the same time,
the Commi ttee of Governors of the central banks
of the Member States of the European Economi c
Communi ty, whi ch had pl ayed an i ncreasi ngl y
i mportant rol e i n monetary cooperati on si nce i t
was establ i shed i n May 1964, was gi ven addi ti onal
responsi bi l i ti es.
In order for Stages Two and Three to take place, the
Treaty establ i shi ng the European Communi ty (the
so-cal l ed Treaty of Rome) had to be revi sed so
that the requi red i nsti tuti onal structure coul d be
established. For this purpose, an Intergovernmental
Conference on EMU was hel d i n 1991 i n paral l el
with the Intergovernmental Conference on political
union. The Committee of Governors submitted the
draf t Statute of the ESCB and of the ECB to the
I ntergovernmental Conference. The negoti ati ons
resulted in the Treaty on European Union, which was
agreed in December 1991 and signed in Maastricht
on 7 February 1992. However, owi ng to del ays i n
the ratification process, it did not come into force
unti l 1 November 1993.
5.1
2 1 3 4 5
5. 1 A shor t hi stori cal over vi ew
5. 2 The i nsti tuti onal framework
5. 3 The ECBs monetary pol i cy strategy
5. 4 Over vi ew of the Eurosystems operati onal framework
50
T HE ECB S MONETARY
5
51
POL I CY
1962 The European Commission makes its first proposal
(Marjolin-Memorandum) for economic and monetary
union.
May 1964 A Committee of Governors of central banks of the
Member States of the European Economic Community
(EEC) is formed to institutionalise cooperation among
EEC central banks.
1970 The Werner Report sets out a plan to realise an
economic and monetary union in the Community by
1980.
Apr. 1972 A system (the snake) for the progressive narrowing of
the margins of fluctuation between the currencies of the
Member States of the European Economic Community is
established.
Apr. 1973 The European Monetary Cooperation Fund (EMCF) is set
up to ensure the proper operation of the snake.
Mar. 1979 The European Monetary System (EMS) is created.
Feb. 1986 The Single European Act (SEA) is signed.
June 1988 The European Council mandates a committee of experts
under the chairmanship of Jacques Delors (the Delors
Committee) to make proposals for the realisation of EMU.
May 1989 The Delors Report is submitted to the European Council.
June The European Council agrees on the realisation of EMU
in three stages.
July 1990 Stage One of EMU begins.
December An Intergovernmental Conference to prepare for Stages
Two and Three of EMU is launched.
Feb. 1992 The Treaty on European Union (the Maastricht Treaty)
is signed.
Oct. 1993 Frankfurt am Main is chosen as the seat of the European
Monetary Institute (EMI) and of the ECB, and a President
of the EMI is nominated.
November The Treaty on European Union enters into force.
December Alexandre Lamfalussy is appointed President of the EMI,
to be established on 1 January 1994.
Jan. 1994 Stage Two of EMU begins and the EMI is established.
Dec. 1995 The Madrid European Council decides on the name of
the single currency and sets out the scenario for its
adoption and the cash changeover.
Dec. 1996 The EMI presents specimen banknotes to the European
Council.
June 1997 The European Council agrees on the Stability and
Growth Pact.
May 1998 Bel gi um, Germany, Spai n, France, Irel and, Italy,
Luxembourg, the Netherlands, Austria, Portugal
and Finland are considered to fulfil the necessary
conditions for the adoption of the euro as their single
currency; the Members of the Executive Board of the
ECB are appointed.
June The ECB and the ESCB are established.
October The ECB announces the strategy and the operational
framework for the single monetary policy it will conduct
from January 1999.
Jan. 1999 Stage Three of EMU begins; the euro becomes the single
currency of the euro area; conversion rates are fixed
irrevocably for the former national currencies of the par-
ticipating Member States; a single monetary policy is con-
ducted for the euro area.
Jan. 2001 Greece becomes the 12th Member State to join the euro
area.
Jan. 2002 The euro cash changeover: euro banknotes and coins are
introduced and become sole legal tender in the euro area
by the end of February 2002.
May 2004 The NCBs of the ten new EU Member States join the
ESCB.
Jan. 2007 Bulgaria and Romania bring the total number of EU
Member States to 27 and join the ESCB at the same time.
Slovenia becomes the 13th Member State to join the
euro area.
Jan. 2008 Cyprus and Malta join the euro area, thereby increasing
the number of Member States to 15.
Jan. 2009 Slovakia joins the euro area, bringing the number of
Member States to 16.
Jan. 2011 Estonia joins the euro area, increasing the number of
Member States to 17.
BOX 5. 1 THE ROAD TO THE SI NGLE CURRENCY, THE EURO
52
Stage Two of EMU:
the establishment of the EMI and the ECB
The establ i shment of the European Monetary
Institute (EMI) on 1 January 1994 marked the start
of the second stage of EMU. Henceforth, the
Committee of Governors ceased to exist. The EMIs
transi tory exi stence al so mi rrored the state of
monetary i ntegrati on wi thi n the Communi ty: the
EMI had no responsi bi l i ty for the conduct of
monetary pol i cy i n the European Uni on (thi s
remai ned t he res pons i bi l i t y of t he nat i onal
authori ti es) nor di d i t have any competence for
carryi ng out forei gn exchange i nterventi on.
The two mai n tasks of the EMI were f i rst to
strengthen central bank cooperation and monetary
pol i cy coordi nati on; and second to make the
preparations required for the establishment of the
ESCB, for the conduct of the si ngl e monetary
pol i cy and for the creati on of a si ngl e currency i n
the thi rd stage.
In December 1995 the European Counci l meeti ng
i n Madrid agreed on the name of the European
currency unit to be introduced at the start of Stage
Three, t he euro, and conf i rmed that Stage
Three of EMU would start on 1 J anuary 1999.
A chronol ogi cal sequence of events was pre-
announced for the changeover to the euro. Thi s
scenari o was based mai nly on detai l ed proposal s
drawn up by the EMI. At the same ti me, the EMI
was given the task of carrying out preparatory
work on the future monetary and exchange rate
relationships between the euro area and other EU
countri es. In December 1996 the EMI presented a
report to the European Council which formed the
basi s of a Resol uti on of the European Counci l on
the pri nci pl es and fundamental el ements of the
new exchange rate mechanism (ERM II), which was
adopted i n June 1997.
I n December 1996 the EMI al so presented to the
European Counci l , and subsequently to the publ i c,
the sel ected desi gn seri es for the euro banknotes
to be put i nto ci rcul ati on on 1 J anuary 2002.
In order to both complement and clarify the Treatys
provisions on EMU, in June 1997 the European
Council adopted the Stabi l i ty and Growth Pact to
ensure budgetary discipline in respect of EMU. The
Pact was s uppl ement ed and t he res pect i ve
commi tments enhanced by a Declaration of the
Council in May 1998.
On 2 May 1998 the Counci l of the European
Uni on i n i ts composi ti on of Heads of State or
Government deci ded that 11 Member States
(Bel gi um, Germany, Spai n, France, I rel and, Italy,
Luxembourg, the Netherlands, Austria, Portugal and
Fi nl and) had f ul f i l l ed the condi ti ons necessary
for the adopti on of the si ngl e currency on 1
J anuary 1999.
At the same ti me, the f i nance mi ni sters of the
Member States adopting the single currency agreed,
together wi th the governors of the NCBs, the
European Commi ssi on and the EMI , that the ERM
central rates of the currencies of the participating
Member States woul d be used to determi ne the
i rrevocabl e conversi on rates for the euro.
On 25 May 1998 the governments of the 11
parti ci pati ng Member States of f i ci al ly appoi nted
the Presi dent, the Vi ce-Presi dent and the four
other members of the Executive Board of the ECB.
Their appointment came into effect on 1 June 1998
T HE ECB S MONETARY
In December 1996
the selected design series
for the euro banknotes
was presented.
53
and marked the establ i shment of the ECB. Wi th
this, the EMI had completed its tasks. In accordance
wi th Arti cl e 123 of the Treaty establ i shi ng the
European Community, the EMI went into liquidation.
All the preparatory work entrusted to the EMI was
concluded in good time and the ECB spent the rest
of 1998 carryi ng out fi nal tests of systems and
procedures.
Stage Three of EMU:
the irrevocable fixing of exchange rates
On 1 January 1999 the third and final stage of EMU
began wi th the i rrevocabl e fi xi ng of the exchange
rates of the currenci es of the 11 Member States
whi ch had i ni ti al ly parti ci pated i n monetary uni on
and wi th the conduct of a si ngl e monetary pol i cy
under the responsibility of the ECB. The number of
participating Member States increased to 12 on
1 January 2001, when Greece joined the third stage
of EMU. This followed on from a decision taken on
19 June 2000 by the EU Counci l , i n whi ch i t was
acknowledged that Greece fulfilled the convergence
criteria. In January 2007 the number of participating
countri es changed agai n to 13 wi th the entry of
Slovenia into the euro area. Following the decision
of the EU Counci l on the abrogati on of the
derogation status of Cyprus and Malta, taken on 10
July 2007, Cyprus and Malta joined the Eurosystem
on 1 January 2008. On 1 January 2009 Sl ovaki a
became the 16th EU Member State to j oi n the
euro area. Thi s fol l owed the deci si on of the EU
Counci l on 8 July 2008 whi ch acknowl edged that
Sl ovaki a had f ul f i l l ed the convergence cri teri a.
On 1 January 2011 Estoni a j oi ned the euro area
and became the 17th Member State to j oi n, after
a deci si on by the EU Counci l of 13 July 2010 that
Estoni a f ul fi l l ed the convergence cri teri a.
THE I NSTI TUTI ONAL
FRAMEWORK
The European System of Central Banks
The ECB was established on 1 June 1998 and is one
of the worlds youngest central banks. However, it has
inherited the credibility and expertise of all euro area
NCBs, which together with the ECB implement the
monetary policy for the euro area.
The l egal basi s for the ECB and the ESCB i s the
Treaty establ i shi ng the European Communi ty.
Accordi ng to thi s Treaty, the ESCB is composed of
the ECB and the NCBs of all EU Member States (27
since 1 January 2007). The Statute of the ESCB and
of the ECB is attached to the Treaty as a protocol.
Mandate of the ESCB
The Treaty states that the primary objective of the
ESCB shall be to maintain price stability and that
wi thout prej udi ce to the obj ecti ve of pri ce
stabi l i ty, the ESCB shal l support the general
economi c pol i ci es i n the Communi ty wi th a vi ew
to contributing to the achievement of the objectives
of the Communi ty as l ai d down i n Arti cl e 2.
Arti cl e 2 of the Treaty menti ons as obj ecti ves of
t he Communi t y, i nt er al i a, a hi gh l evel of
empl oyment (), sustai nabl e and non-i nfl ati onary
growth, a hi gh degree of competi ti veness and
convergence of economic performance. The Treaty
thus establ i shes a clear hierarchy of objectives
and assigns overriding importance to price stability.
By focusing the monetary policy of the ECB on this
pri mary obj ecti ve, the Treaty makes i t cl ear that
ensuri ng pri ce stabi l i ty i s the most i mportant
contri buti on that monetary pol i cy can make to
achi evi ng a favourabl e economi c envi ronment and
a hi gh l evel of empl oyment.
5.2
5
POL I CY
54
The Eurosystem
The euro area NCBs and the ECB together form
the Eurosystem. Thi s term was chosen by the
Governi ng Counci l of the ECB to descri be the
arrangement by whi ch the ESCB carri es out i ts
tasks wi thi n the euro area. As l ong as there are
EU Member States which have not yet adopted the
euro, this distinction between the Eurosystem and
the ESCB wi l l need to be made.
T HE ECB S MONETARY
BOX 5. 2 CONVERGENCE CRI TERI A
The conditions for the adoption of the euro are laid
down in Article 121 of the Treaty and the Protocol
annexed to the Treaty on the convergence criteria
referred to i n Arti cl e 121. To assess whether a
Member State has achi eved a hi gh degree of
sustai nabl e convergence, four cri teri a are used:
pri ce stabi l i ty, a sound f i scal posi ti on, exchange
rate stabi l i ty and convergi ng i nterest rates.
The first indent of Article 121(1) of the Treaty
requires the achievement of a high degree of price
stabi l i ty and states that thi s wi l l be apparent
from a rate of i nf l ati on whi ch i s cl ose to that, at
most, of the three best performing Member States
in terms of price stability. Article 1 of the Protocol
states i n addi ti on that the cri teri on on pri ce
stability () shall mean that a Member State has a
price performance that is sustainable and an average
rate of i nfl ati on, observed over a peri od of one
year before the examination, that does not exceed
by more than 1
1
/
2 percentage poi nts that of , at
most, the three best performi ng Member States
i n t erms of pri ce st abi l i t y. I nf l at i on shal l be
measured by means of the consumer pri ce i ndex
on a comparabl e bas i s , t aki ng i nt o account
di f ferences i n nati onal defi ni ti ons.
The second i ndent of Arti cl e 121(1) of the Treaty
requi res the sustai nabi l i ty of the governments
f i nanci al posi ti on and states that thi s wi l l be
apparent from having achieved a budgetary position
without a deficit that is excessive as determined in
accordance wi th Arti cl e 104(6). Arti cl e 2 of the
Protocol states in addition that this criterion ()
shall mean that at the time of the examination the
Member State i s not the subj ect of a Counci l
Decision under Article 104(6) of this Treaty that an
excessi ve def i ci t exi sts.
Under Article 104(1) of the Treaty, Member States
shal l avoi d excessi ve government def i ci ts. The
Commi ssi on exami nes compl i ance wi th budgetary
di sci pl i ne, based i n parti cul ar on the fol l owi ng
cri teri a:
(a) whether the rati o of the pl anned or actual
government def i ci t to gross domesti c product
exceeds a reference value (defined in the Protocol
The NCBs of the Member States whi ch have not
adopted the euro are not involved in the decision-
maki ng regardi ng the si ngl e monetary pol i cy for
the euro area and conduct thei r own monetary
pol i ci es. An EU country can adopt the euro at a
l ater stage but onl y once i t has f ul f i l l ed the
convergence cri teri a (see Box 5. 2 bel ow for a
more detai l ed descri pti on).
5
A monetary policy which
credibly maintains price sta-
bility has an important posi-
tive impact on welfare.
POL I CY
on the excessive deficit procedure as 3 % of GDP),
unless:
I either the ratio has declined substantially and
continuously and reached a level that comes close
to the reference value;
I or, alternatively, the excess over the reference
value is only exceptional and temporary and the
ratio comes close to the reference value;
(b) whether the ratio of government debt to gross
domest i c product exceeds a ref erence val ue
(defi ned i n the Protocol on the excessi ve def i ci t
procedure as 60 % of GDP), unl ess the rati o i s
si gni f i cant l y di mi ni shi ng and approachi ng t he
reference val ue at a sati sfactory pace.
The thi rd i ndent of Arti cl e 121(1) of the Treaty
requires the observance of the normal fluctuation
margi ns provi ded f or by t he exchange rat e
mechani sm of the European Monetary System,
for at l east two years, wi thout deval ui ng agai nst
the currency of any other Member State. Article 3
of the Protocol states in addition that the criterion
on participation in the exchange rate mechanism of
the European Monetary System () shal l mean
that a Member State has respected the normal
fl uctuati on margi ns provi ded for by the exchange
rate mechanism of the European Monetary System
wi thout severe tensi ons for at l east two years
before the exami nati on. In parti cul ar, the Member
State shall not have devalued its currencys bilateral
central rate agai nst any other Member States
currency on its own initiative for the same period.
The fourth i ndent of Arti cl e 121(1) of the Treaty
requires the durability of convergence achieved by
the Member State and of i ts parti ci pati on i n the
exchange r at e mechani s m of t he European
Monetary System bei ng refl ected i n the l ong-term
i nterest rate l evel s. Arti cl e 4 of the Protocol
states i n addi ti on that the cri teri on on the
convergence of interest rates () shall mean that,
observed over a peri od of one year before the
exami nati on, a Member State has had an average
nomi nal l ong-term i nterest rate that does not
exceed by more than 2 percentage points that of, at
most, the three best performing Member States in
terms of pri ce stabi l i ty. I nterest rates shal l be
measured on the basi s of l ong-term government
bonds or comparable securities, taking into account
di f ferences i n nati onal def i ni ti ons.
I n addi ti on to these economi c requi rements, the
convergence criteria also require there to be legal
convergence to ensure that nati onal l egi sl ati on,
i ncl udi ng the statutes of NCBs, i s compati bl e wi th
both the Treaty and the Statute of the ESCB and of
the ECB. The Treaty requi res the ECB and the
Commi ssi on to report to the Counci l of the
European Union at least once every two years or at
the request of a Member State wi th a derogati on,
on the progress made by Member States i n terms
of thei r ful fi l ment of the convergence cri teri a. On
the basi s of the convergence reports submi tted
separately by the ECB and the Commission, and on
the basi s of a proposal by the Commi ssi on, the
Council, having consulted the European Parliament
and having met in the composition of Heads of State
or Government, may decide on the fulfilment of the
criteria by a Member State and allow it to join the
euro area. Si nce the begi nni ng of Stage Three, the
ECB has prepared several convergence reports.
55
56
and its basic tasks
The basic tasks of the Eurosystem are to:
I define and implement the monetary policy for the
euro area;
I conduct foreign exchange operations and to hold
and manage the official foreign reserves of the
euro area countries;
I promote the smooth operation of payment systems.
Further tasks are to:
I authorise the issue of banknotes in the euro area;
I give opinions and advice on draft Community acts
and draft national legislation;
I col l ect the necessary stati sti cal i nformati on
either from national authorities or directly from
economic agents, e. g. financial institutions;
I contribute to the smooth conduct of policies
pursued by the authorities in charge of prudential
supervision of credit institutions and the stability
of the financial system.
The Governing Council
The highest decision-making body of the ECB is the
Governing Council. It consists of the six members of
the Executive Board and the governors of the NCBs
of the euro area. Both the Governing Council and the
Executive Board are chaired by the President of the
ECB (see also the chart below).
The key task of the Governi ng Counci l i s to
formul ate the monetary pol i cy for the euro area.
Speci f i cal ly, i t has the power to determi ne the
i nterest rates at whi ch credi t i nsti tuti ons may
obtain liquidity (money) from the Eurosystem. Thus
the Governing Council indirectly influences interest
rates throughout the euro area economy, i ncl udi ng
the rates that credi t i nsti tuti ons charge thei r
customers for loans and those that savers earn on
thei r deposi ts. The Governi ng Counci l ful f i l s i ts
responsi bi l i ti es by adopti ng gui del i nes and taki ng
deci si ons.
The Executive Board
The Executi ve Board of the ECB consi sts of the
Presi dent , t he Vi ce- Presi dent and f our ot her
members. Al l are appoi nted by common accord of
the Heads of State or Government of the countries
whi ch form the euro area. The Executi ve Board i s
responsi bl e for i mpl ementi ng the monetary pol i cy
as formul ated by the Governi ng Counci l and gi ves
the necessary i nstructi ons to the NCBs for thi s
purpose. I t al so prepares the meeti ngs of the
Governi ng Counci l and manages the day-to-day
busi ness of the ECB.
T HE ECB S MONETARY
Governors
of the euro area NCBs
Governors
of the NCBs
of all EU Member States

Four other members
of the Executive Board
Four other members
of the Executive Board
President
Vice-President
President
Vice-President
President
Vice-President
EXECUTIVE BOARD
THE DECISION-MAKING BODIES OF THE ECB
GENERAL COUNCIL GOVERNING COUNCIL
CHART THE DECI S I ON- MAKI NG BODI ES OF THE ECB
Source: European Central Bank (2004), The monetary policy of the ECB, p. 10.
57
The General Council
The thi rd deci si on-maki ng body of the ECB i s the
General Counci l . It compri ses the Presi dent and
the Vi ce-Presi dent of the ECB and the governors
and presi dents of al l 27 NCBs of the EU Member
States. The General Counci l has no responsi bi l i ty
for monetary pol i cy deci si ons i n the euro area. It
contri butes to the coordi nati on of monetar y
pol i ci es of the Member States that have not yet
adopted the euro and to the preparati ons for the
possi bl e enl argement of the euro area.
Independence
There are good reasons to entrust the task of
maintaining price stability to an independent central
bank not subject to potential political pressures. In
l i ne wi th the provi si ons of the Treaty establ i shi ng
the European Community, the Eurosystem enjoys full
independence in performing its tasks: neither the
ECB, nor the NCBs i n the Eurosystem, nor any
member of thei r deci si on-maki ng bodi es may
seek or take instructions from any other body. The
Communi t y i ns t i t ut i ons and bodi es and t he
governments of the Member States are bound to
respect this principle and must not seek to influence
the members of the decision-making bodies of the
ECB or of the NCBs. Furthermore, the Eurosystem
may not grant any l oans to Community bodies or
national government entities. This shields it further
from political interference. The Eurosystem has all
the i nstruments and competenci es i t needs to
conduct an efficient monetary policy. The members
of the ECBs deci si on-maki ng bodi es have l ong
terms of of f i ce and can be di smi ssed only for
seri ous mi sconduct or the i nabi l i ty to perform
t hei r dut i es . The ECB has i t s own budget ,
i ndependent of that of the European Communi ty.
This keeps the administration of the ECB separate
f rom the f i nanci al i nterests of the Communi ty.
Capital of the ECB
The capi tal of the ECB does not come f rom the
European Community but has been subscribed and
pai d up by the NCBs. The share of each Member
State i n the European Uni ons gross domesti c
product and population determines the amount of
each NCBs subscri pti on.
THE ECB S MONETARY
POLI CY STRATEGY
GENERAL PRI NCI PLES
The mandate and task of monetary policy
As al ready menti oned, the Treaty establ i shi ng the
European Community assigns to the Eurosystem the
primary objective of maintaining price stability in the
euro area. In parti cul ar i t states that the pri mary
obj ecti ve of the ESCB shal l be to mai ntai n pri ce
stabi l i ty.
The chal l enge f aced by the ECB can be stated as
fol l ows: the Governi ng Counci l of the ECB has to
i nfl uence condi ti ons i n the money market, and
thereby the l evel of short-term i nterest rates,
to ensure that pri ce stabi l i ty i s mai ntai ned over
t he medi um t erm. Some key pri nci pl es of a
successf ul monetary pol i cy are expl ai ned bel ow.
Monetary policy should firmly anchor
inflation expectations
First, monetary policy is considerably more effective
if it firmly anchors inflation expectations (see also
Section 3.3). In this regard, central banks should
specify thei r goal s, el aborate them and sti ck to a
consi stent and systematic method for conducting
monetary policy, as well as communicate clearly and
openly. These are key elements for acquiring a high
l evel of credi bi l i ty, a necessary precondi ti on for
i nf l uenci ng the expectati ons of economi c actors.
5.3
5
POL I CY
58
must be forward-looking
Second, owi ng to the l ags i n the transmi ssi on
process (see Secti on 4. 3), changes i n monetary
pol i cy today wi l l only affect the pri ce l evel after a
number of quarters or years. Thi s means that
central banks need to ascertain what policy stance
is needed in order to maintain price stability in the
future, once the transmi ssi on l ags have unwound.
In thi s sense, monetary pol i cy must be forward-
l ooki ng.
focus on the medium term
As the transmi ssi on l ags make i t i mpossi bl e for
monetary pol i cy to off set unanti ci pated shocks
to the pri ce l evel (for exampl e, those caused by
changes in international commodity prices or indirect
taxes) in the short run, some short-term volatility in
i nfl ati on rates i s i nevi tabl e (see al so Secti on 4. 4).
In addition, owing to the complexity of the monetary
pol i cy transmi ssi on process, there i s always a hi gh
degree of uncertai nty surroundi ng the ef fects of
economi c shocks and monetary pol i cy. For these
reasons, monetary pol i cy shoul d have a medi um-
term ori entati on i n order to avoi d excessi ve
acti vi sm and the i ntroducti on of unnecessar y
vol ati l i ty i nto the real economy.
and be broadly based
Fi nal ly, j ust l i ke any other central bank, the ECB
faces considerable uncertainty about the reliability
of economi c i ndi cators, the structure of the euro
area economy and the monetary policy transmission
mechani sm, among other thi ngs. A successf ul
monetar y pol i cy theref ore has to be broadl y
based, taking into account all relevant information in
order to understand the factors dri vi ng economi c
devel opments, and cannot rely on a small set of
indicators or a single model of the economy.
The role of the strategy: a comprehensive
framework for monetary policy decisions
The Governi ng Counci l of the ECB has adopted
and announced a monetary pol i cy strategy to
ensure a consistent and systematic approach to
monetary policy deci si ons. Thi s monetary pol i cy
strategy embodi es the above-menti oned general
principles in order to meet the challenges facing the
central bank. I t ai ms to provi de a comprehensi ve
f r amewor k wi t hi n whi ch deci s i ons on t he
appropri ate l evel of short-term i nterest rates can
be taken and communi cated to the publ i c.
The main elements of the ECBs monetary
policy strategy
The first element of the ECBs monetary policy
strategy is a quantitative definition of price stability.
In addition, the strategy establishes a framework to
ensure that the Governing Council assesses all the
rel evant i nformati on and analyses needed to take
monetary policy decisions such that price stability
over the medium term is maintained. The remaining
sections of this chapter describe these elements in
detai l .
T HE ECB S MONETARY
Monetary policy must
be forward-looking
59
THE QUANTI TATI VE DEFI NI TI ON
OF PRI CE STABI LI TY
Primary objective
The primary objective of the Eurosystem is to
maintain pri ce stabi l i ty i n the euro area, thus
protecti ng the purchasi ng power of the euro. As
discussed earlier, ensuring stable prices is the most
i mportant contri buti on that monetary pol i cy can
make i n order to achieve a favourable economic
environment and a high l evel of empl oyment. Both
inflation and deflation can be very costly to society
economically and socially speaking (see in particular
Secti on 3. 3). Wi thout prej udi ce to i ts pri mary
obj ecti ve of pri ce stabi l i ty, the Eurosystem al so
supports the general economi c pol i ci es i n the
European Community. Furthermore, the Eurosystem
acts i n accordance wi th the pri nci pl es of an open
market economy, as st i pul at ed by t he Treat y
establ i shi ng the European Communi ty.
The ECB has defined price stability
in quantitative terms
While the Treaty clearly establishes the maintenance
of price stability as the primary objective of the ECB,
it does not give a precise definition. In order to
specify this objective more precisely, the Governing
Counci l of the ECB announced the f ol l owi ng
quantitative definition in 1998: Price stability shall
be def i ned as a year-on-year i ncrease i n the
Harmonised Index of Consumer Prices (HICP) for
the euro area of bel ow 2 %. Pri ce stabi l i ty i s to be
mai ntai ned over the medi um term. In 2003, the
Governing Council further clarified that, within the
definition, it aims to maintain inflation rates below
but cl ose to 2 % over the medi um term.
The definition both anchors inflation
expectations and adds to the
ECBs transparency and accountability
The Gover ni ng Counci l deci ded t o publ i cl y
announce a quantitative definition of price stability
for a number of reasons. Fi rst, by cl ari f yi ng how
the Governing Council interprets the goal that it has
been assigned by the Treaty, the definition helps to
make the monetary pol i cy f ramework easi er to
understand (i . e. i t makes monetary pol i cy more
transparent). Second, the definition of price stability
provi des a cl ear and measurabl e yardsti ck agai nst
whi ch the publ i c can hol d the ECB accountabl e.
I n case of devi ati ons of pri ce devel opments f rom
the defi ni ti on of pri ce stabi l i ty, the ECB woul d be
requi red t o provi de an expl anat i on f or such
devi at i ons and t o expl ai n how i t i nt ends t o
re-establ i sh pri ce stabi l i ty wi thi n an acceptabl e
period of time. Finally, the definition gives guidance
t o t he publ i c , al l owi ng i t t o f or m i t s own
expectati ons regardi ng future pri ce devel opments
(see al so Box 3. 2).
5
The definition of price
stability gives guidance to
the public, allowing it to
form its own expectations
regarding future price
developments.
POL I CY
60
The conceptual work related to the compilation of
the HI CP for the euro area i s carri ed out by the
European Commission (Eurostat) in close liaison with
the nati onal stati sti cal i nsti tutes. As key users, the
ECB and its forerunner, the EMI, have been closely
i nvol ved i n thi s work. The HICP data rel eased by
Eurostat are available from January 1995 onwards.
Based on consumer expenditure weights applicable
for 2010, goods account for 58 % and services for
42 % of t he HI CP ( see t he t abl e bel ow) .
A breakdown of the overal l HI CP i nto i ndi vi dual
components makes i t easi er to see the vari ous
economic factors that have an impact on consumer
price developments. For example, developments in
the energy price component are closely related to
oi l pri ce movements. Food pri ces are di vi ded i nto
processed and unprocessed foods, because pri ces
for the latter are strongly influenced by factors such
as weather conditions and seasonal patterns, while
such f actors have l ess of an i mpact on processed
food prices. Services prices are subdivided into five
components which, on account of different market
condi ti ons, typi cal l y show di f f erences i n thei r
respecti ve devel opments.
As a resul t of i ts harmoni sati on and stati sti cal
i mprovements ai med at enhanci ng i ts accuracy,
rel i abi l i ty and ti mel i ness, the HI CP has become a
high-quality, international-standard price index and
a broadly comparabl e i ndi cator across countri es.
Nevertheless, improvements are still being made in
vari ous fi el ds.
Features of the definition:
focus on the euro area as a whole
The defi ni ti on of pri ce stabi l i ty has a number of
noteworthy features. Fi rst, the ECB has a euro
area-wide mandate. Accordingly, decisions regarding
the si ngl e monetary pol i cy ai m to achi eve pri ce
stability in the euro area as a whole. This focus on
the euro area as a whole is the natural consequence
of the fact that, within a monetary union, monetary
pol i cy can only steer the average money market
i nterest rate l evel i n the area, i . e. i t cannot set
different interest rates for different regions of the
euro area.
The HICP
The def i ni ti on al so i denti f i es a speci f i c pri ce
index namely the HICP for the euro area as the
i ndex to be used for assessi ng whether pri ce
stabi l i ty has been achi eved. The use of a broad
price index ensures the transparency of the ECBs
commitment to full and effective protection against
l osses i n the purchasing power of money (see also
Secti on 3. 2).
The HI CP, whi ch i s rel eased by Eurostat, the
Statistical Office of the European Union, is the key
measure for pri ce devel opments i n the euro area.
This index has been harmonised across the various
countries of the euro area with the aim of measuring
pri ce devel opments on a comparabl e basi s. The
HICP i s the i ndex that most cl osely al l ows one to
approximate the changes over time in the pri ce of
a representative basket of consumer expenditures
i n the euro area (see Box 5. 3).
T HE ECB S MONETARY
BOX 5. 3 CONS TRUCTI ON AND FEATURES OF THE HI CP
61
5
TABLE WEI GHTS OF THE MAI N EURO AREA
HI CP COMPONENTS APPLI CABLE FOR 2010
Overall index 100.0
Goods prices 58.0*
Unprocessed food 7.3
Processed food 11.9
Non-energy i ndustri al goods 29.3
Energy 9.6
Services 42.0
Housi ng servi ces 10.2
Transport 6.6
Communi cati on 3.3
Recreati on and personal servi ces 14.9
Mi scel l aneous 7.1
* Figures may not add up due to rounding. Source: Eurostat.
Reasons for aiming at inflation rates
of below but close to 2 %
By referri ng to an i ncrease i n the HICP of bel ow
2 %, the definition makes it clear that both inflation
above 2 % and deflation (i.e. declines in the price
l evel ) are i nconsi stent wi th pri ce stabi l i ty. In thi s
respect, the expl i ci t i ndi cati on by the ECB to ai m
to mai ntai n the i nf l ati on rate at a l evel bel ow but
cl ose to 2 % si gnal s i ts commi tment to provi de an
adequate margi n to avoi d the ri sks of defl ati on
(see Secti on 3. 1 and al so Box 5. 4).
POL I CY
BOX 5. 4 A SAFETY MARGI N AGAI NST DEFLATI ON
Referring to an increase in the HICP of below but
cl ose to 2 % provi des a safety margi n agai nst
def l ati on.
Whi l e def l ati on i mpl i es si mi l ar costs f or the
economy as i nfl ati on, i t i s parti cul arly i mportant
that deflation is avoided because, once it occurs, it
may become entrenched as a result of the fact that
nomi nal i nterest rates cannot fal l bel ow zero as,
normally, nobody would be willing to lend money to
someone el se when he expects l ess money to be
returned to hi m af ter a certai n peri od. I n a
defl ati onary envi ronment, monetary pol i cy may
therefore not be abl e to suf f i ci ently sti mul ate
aggregat e demand by usi ng i t s i nt erest rat e
i nstrument. Any attempt to bri ng the nomi nal
i nterest rate bel ow zero woul d f ai l , as the publ i c
woul d prefer to have cash rather than to l end or
hol d deposi ts at a negati ve rate. Al though some
monetary pol i cy acti ons can sti l l be carri ed out
even when nomi nal i nterest rates are at zero, the
ef fecti veness of these al ternati ve pol i ci es i s not
f ul ly certai n. I t i s thus preferabl e for monetary
pol i cy to have a safety margi n agai nst def l ati on.
62
An economy i s conti nuously subj ect to l argely
unf ores eeabl e s hocks t hat al s o af f ect pr i ce
devel opments. At the same ti me, monetary pol i cy
can only affect price developments with significant
time lags, which are variable and, like most economic
rel at i ons hi ps , hi ghl y uncer t ai n. Agai ns t t hi s
background, it would be impossible for any central
bank to keep inflation at a specific point target at all
times or to bring it back to a desired level within a
very short period of time. Consequently, monetary
policy needs to act in a forward-looking manner and
can only maintain price stability over longer periods
of ti me. Thi s i s the reasoni ng that l i es at the core
of the ECBs medi um-term ori entati on.
The medi um term noti on del i berately retai ns
some flexibility with regard to an exact time frame.
Thi s refl ects the fact that i t i s not advi sabl e to
specify ex ante a precise horizon for the conduct of
monetary policy, since the transmission mechanism
spans a vari abl e, uncertai n peri od of ti me. An
excessi vely aggressi ve pol i cy response to restore
pri ce stabi l i ty wi thi n a very short ti me span may,
under these circumstances, risk incurring a significant
cost i n terms of output and empl oyment vol ati l i ty
whi ch, over a l onger hori zon, coul d al so affect
pri ce devel opments. I n these cases, i t i s wi dely
recogni sed that a gradual response of monetary
pol i cy i s appropri ate both to avoi d unnecessari ly
high volatility in real activity and to maintain price
stabi l i ty over a l onger hori zon. Thus, the medi um-
term ori entati on al so gi ves the ECB the fl exi bi l i ty
requi red to respond i n an appropri ate manner to
the di f ferent economi c shocks that mi ght occur.
At the same time, it should be clear that, from an ex
post perspective, the ECB can be held accountable
only for trends i n i nf l ati on.
By aiming at an increase of the HICP of below but
close to 2 %, a possible measurement bias in the
HICP and the potenti al i mpl i cati ons of i nf l ati on
di fferenti al s i n the euro area are al so taken i nto
account.
The medium-term orientation
Fi nal ly, a key aspect of the ECBs monetary pol i cy
i s that i t ai ms to pursue pri ce stabi l i ty over the
medium term. As outlined above, this reflects the
consensus t hat monet ar y pol i cy cannot , and
therefore shoul d not, ai m to attempt to fi ne-tune
devel opments i n pri ces or i nf l ati on over short
hori zons of a few weeks or months (see al so
Secti on 4. 4). Changes i n monetary pol i cy only
affect pri ces wi th a ti me l ag, and the magni tude of
the eventual i mpact i s uncertai n. Thi s i mpl i es that
monetary pol i cy cannot of fset al l unanti ci pated
di sturbances to the pri ce l evel . Some short-term
vol ati l i ty i n i nfl ati on i s therefore i nevi tabl e.
T HE ECB S MONETARY
BOX 5. 5 THE MEDI UM- TERM ORI ENTATI ON OF THE ECB S
MONETARY POLI CY
63
THE TWO PI LLARS OF THE ECB S
MONETARY POLI CY STRATEGY
The two-pillar framework is a tool
for organising information
The ECBs approach to organi si ng, eval uati ng and
cross-checking the information relevant for assessing
the risks to price stability is based on two analytical
perspecti ves, referred to as the two pi l l ars.
based on two analytical perspectives
In the ECBs strategy, monetary policy decisions are
based on a comprehensi ve analysi s of the ri sks to
pri ce stabi l i ty. Thi s analysi s i s organi sed on the
basi s of two compl ementary perspecti ves on the
determi nati on of pri ce devel opments. The fi rst
perspecti ve i s ai med at assessi ng the short to
medium-term determinants of price developments,
with a focus on real activity and financial conditions
i n the economy. I t takes account of the f act
that pri ce devel opments over those hori zons are
i nf l uenced l argely by the interplay of supply and
demand in the goods, services and factor markets
(see al so Secti on 4. 4). The ECB refers to thi s as
the economi c analysi s. The second perspecti ve,
referred to as the monetary analysi s, focuses on
a longer-term horizon, exploiting the long-run link
between money and pri ces (see al so Secti on 4. 5).
The monetary analysis serves mainly as a means of
cross- checki ng, f rom a medi um t o l ong- t erm
perspective, the short to medium-term indications
for monetary pol i cy comi ng from the economi c
analysi s.
to ensure that no relevant
information is lost
The two-pillar approach is designed to ensure that
al l rel evant i nformati on i s used i n the assessment
of the ri sks to pri ce stabi l i ty and that appropri ate
attenti on i s pai d to di fferent perspecti ves and the
cross-checking of information in order to come to
an overall judgement of the risks to price stability.
It represents, and conveys to the public, the notion
of diversified analysis and ensures robust decision-
maki ng based on di fferent analyti cal perspecti ves.
ECONOMI C ANALYSI S
Analysis of short to medium-term risks
to price stability
The economi c anal ysi s f ocuses mai nl y on the
assessment of current economi c and f i nanci al
devel opments and the i mpl i ed short to medi um-
term ri sks to pri ce stabi l i ty. The economi c and
f i nanci al vari abl es that are the subj ect of thi s
anal ysi s i ncl ude, for exampl e, devel opments i n
over al l out put ; aggregat e demand and i t s
components; fiscal policy; capital and labour market
condi t i ons; a broad range of pri ce and cost
indicators; developments in the exchange rate, the
gl obal economy and the bal ance of payments;
financial markets; and the balance sheet positions of
euro area sectors. Al l these f actors are hel pf ul i n
assessi ng the dynami cs of real acti vi ty and the
likely development of prices from the perspective
of the interplay between supply and demand in the
goods, servi ces and f actor markets at shorter
hori zons (see al so Secti on 4. 4).
5
Price developments
are influenced largely
by the interplay of supply
and demand in the goods,
services and factor markets.
POL I CY
64
T HE ECB S MONETARY
In the framework of its economic analysis, the ECB
f ocuses mai nl y on the assessment of current
economi c and f i nanci al devel opments and the
implied short to medium-term risks to price stability.
Regardi ng the analysi s of real economy i ndi cators,
the ECB regularly reviews developments in overall
output, demand and labour market conditions, a
broad range of pri ce and cost i ndi cators, and
fiscal policy, as well as the balance of payments for
the euro area. For i nstance, i n terms of pri ce and
cost devel opments, al ongsi de the HI CP and i ts
components, pri ce devel opments i n the i ndustri al
sector, as measured by producer prices, are analysed
because changes i n producti on costs may feed
through to consumer prices. Labour costs, which are
an i mportant el ement of overal l producti on costs,
may have a si gni fi cant i mpact on pri ce formati on.
Labour cost stati stics also provide information on
the competi ti veness of the euro area economy.
Second, indicators of output and demand (national
accounts, short-term statistics on activity in industry
and servi ces, orders, and qual i tati ve survey data)
provide information on the cyclical position of the
economy, which in turn is relevant for the analysis
of prospects for price developments. Furthermore,
labour market data (on employment, unemployment,
vacanci es and l abour market parti ci pati on) are
important for monitoring conjunctural developments
and assessing structural changes in the functioning
of t he euro area economy. Moreover, t he
government sector represents a substantial part of
economic activity; information on both financial and
non-f i nanci al publ i c sector accounts i s essenti al .
Thi rd, bal ance of payments stati sti cs, al ong wi th
external trade stati sti cs, provi de i nformati on on
devel opments i n exports and i mports whi ch may
affect i nf l ati onary pressures vi a thei r i mpact on
demand conditions. These data also allow external
trade pri ces currently proxi ed by export and
i mport uni t val ue i ndi ces to be moni tored.
These i ndi ces hel p to assess, i n parti cul ar, the
potential impact on import prices of movements in
the exchange rate and changes i n commodi ty
pri ces (such as oi l ). In short, these i ndi cators hel p
t o as s es s movement s i n aggregat e demand,
aggregat e suppl y and t he degree of capaci t y
uti l i sati on.
Devel opments i n f i nanci al market i ndi cators and
asset prices are also closely monitored. Movements
i n asset pri ces may af fect pri ce devel opments vi a
i ncome and weal th effects. For exampl e, as equi ty
pri ces ri se, share-owni ng househol ds become
weal t hi er and may choose t o i ncrease t hei r
consumpti on. Thi s wi l l add to consumer demand
and may f uel domesti c i nf l ati onar y pressures.
Conversely, when equi ty pri ces f al l , househol ds
may well reduce consumption. An additional way in
which asset prices can have an impact on aggregate
demand i s vi a the val ue of col l ateral that al l ows
borrowers to obtai n more l oans and/or to reduce
t he ri sk premi a demanded by l enders/ banks.
Lendi ng deci si ons are of ten i nf l uenced to a l arge
extent by the amount of col l ateral . I f the val ue of
col l ateral f al l s, then l oans wi l l become more
expensive and may even be difficult to obtain at all,
wi t h t he resul t t hat spendi ng, and t heref ore
demand, wi l l f al l .
BOX 5. 6 REAL ECONOMI C AND FI NANCI AL I NDI CATORS
65
5
POL I CY
Asset prices and financial yields can also be analysed
to derive information about the expectations of the
fi nanci al markets, i ncl udi ng expected future pri ce
developments. For example, when buying and selling
bonds, f i nanci al market parti ci pants i mpl i ci tl y
reveal their expectations about future developments
in real interest rates and inflation (see also Box 3.2).
Using a variety of techni ques, the ECB can analyse
fi nanci al pri ces to extract the markets i mpl i ci t
expectati ons about future devel opments. Asset
markets, and therefore asset prices, are by their very
nature forward-l ooki ng. Changes i n asset pri ces
therefore largely reflect news information about
devel opments that the fi nanci al markets had not
been expecti ng. I n thi s sense, the moni tori ng of
asset pri ces mi ght hel p to i denti fy shocks that are
currently hitting the economy, in particular shocks to
expectations about future economic developments.
By analysing financial markets, statistical information
on fi nanci al asset pri ces from vari ous sources can
al so be assessed. I n addi ti on, the ECB col l ects
certai n stati sti cal i nformati on i tsel f .
Devel opments i n the exchange rate are al so
cl osely assessed for thei r i mpl i cati ons for pri ce
stabi l i ty. Exchange rate movements have a di rect
effect on price developments through their impact
on i mport pri ces. Al though the euro area i s a
rel ati vel y cl osed economy compared wi th i ts
i ndi vi dual member countri es, i mport pri ces do
af fect domesti c producer and consumer pri ce
devel opments. Changes i n the exchange rate
may al so al t er t he pri ce compet i t i veness of
domesti cal l y produced goods on i nternati onal
markets, thereby i nf l uenci ng demand condi ti ons
and, potenti al ly, the outl ook for pri ces.
helps to reveal the nature of shocks
In this analysis, due attention is paid to the need to
identify the origin and the nature of shocks hitting
the economy, thei r ef fects on cost and pri ci ng
behaviour and the short to medium-term prospects
for their propagation in the economy. For example,
the appropri ate monetar y pol i cy response to
inflationary consequences of a temporary rise in the
international price of oil might be different from the
appropri ate response to hi gher i nfl ati on resul ti ng
from the labour cost implications of wage increases
not matched by productivity growth. The former is
likely to result in a transient and short-lived increase
in inflation which may quickly reverse. As such, if this
shock does not lead to higher inflation expectations,
i t may pose l i ttl e threat to pri ce stabi l i ty over
the medi um term. I n the case of excessi ve wage
increases, there is the danger that a self-sustaining
spi ral of hi gher costs, hi gher pri ces and hi gher
wage demands may be created. To prevent such a
spi ral f rom occurri ng, a strong monetary pol i cy
acti on to reaffi rm the central banks commi tment
to the mai ntenance of pri ce stabi l i ty, thereby
hel pi ng to stabi l i se i nfl ati on expectati ons, may be
the best response.
To take appropri ate deci si ons, the Governi ng
Counci l needs t o have a comprehensi ve
understanding of the prevailing economic situation
and must be aware of the speci f i c nature and
magnitude of any economic disturbances threatening
price stability.
66
The word proj ect i ons i s used i n order t o
emphasi se that the publ i shed proj ecti ons are the
resul ts of a scenari o based on a set of underlyi ng
techni cal assumpti ons. In parti cul ar, si nce June
2006, the Eurosystem proj ecti ons are based on
the techni cal assumpti on that short-term market
interest rates move in line with market expectations
r at her t han, as previ ous l y as s umed, remai n
constant over the proj ecti on hori zon.
Whi l e such proj ecti ons are of ten used to best
inform monetary policy decision-makers about the
outcome of possible future scenarios, this does not
necessarily imply that the scenario will materialise
i n practi ce. The macroeconomi c proj ecti ons of
inflation by Eurosystem staff should not, under any
ci rcums t ances , be s een as ques t i oni ng t he
commi t ment of t he Gover ni ng Counci l t o
mai ntai ni ng price stability over the medium term.
Wage and price-setters (i . e. the government, fi rms
and hous ehol ds ) s houl d rel y on t he ECBs
quant i t at i ve def i ni t i on of pri ce st abi l i t y and
especi al ly the ai m to keep i nf l ati on bel ow, but
close to, 2 % as the best prediction of medium and
l ong-term pri ce devel opments.
Al t hough t hey pl ay a us ef ul rol e , t he s t af f
macroeconomic projections have their limitations.
First, the final projection depends to a considerable
extent on the underlying conceptual framework and
the techni ques empl oyed. Any such f ramework i s
bound to be a si mpl i fi cati on of real i ty and may, on
occasi on, negl ect the key i ssues that are rel evant
for monetary policy. Second, economic projections
can only provi de a summary descri pti on of the
economy, and thus do not i ncorporate al l rel evant
i nformati on. I n parti cul ar, i mportant i nformati on,
such as that contai ned i n monetary aggregates, i s
not easi ly i ntegrated i nto the f ramework used to
produce the projections, or information may change
after the proj ecti ons are finalised. Third, expert
views are inevitably incorporated into projections,
and there can be good reasons not to agree wi th
parti cul ar vi ews. Fourth, proj ecti ons are always
based on speci f i c assumpti ons such as those
concerning oil prices or exchange rates which can
change rapi dly, maki ng the proj ecti ons outdated.
For al l t hese reasons, st af f macroeconomi c
proj ect i ons pl ay an i mpor t ant but not al l -
encompassing role in the ECBs monetary policy
strategy. The Governing Council eval uates them
together wi th many other pi eces of information
and forms of analysis organised within the two-pillar
framework. These include monetary analysis and
analyses of financial prices, individual indicators
and t he f orecast s of ot her i nst i t ut i ons. The
Governi ng Counci l nei ther assumes responsi bi l i ty
for the projections nor uses the staff projections as
its only tool for organi si ng and communi cati ng i ts
assessment.
and includes macroeconomic projections
In the context of the economi c analysi s, the
Eurosystems staff macroeconomi c proj ecti on
exercises play an important role. The projections,
whi ch are produced by t he st af f , hel p to
structure and summari se a l arge amount of
economi c data and ensure consi stency across
di f ferent sources of economi c evi dence. I n
this respect, they are a key element in sharpening
the assessment of economic prospects and the
short to medi um-term fluctuations of inflation
around i ts trend.
T HE ECB S MONETARY
BOX 5. 7 EURO AREA MACROECONOMI C PROJ ECTI ONS
5
67
MONETARY ANALYSI S
Money provides a nominal anchor
The ECB singles out money from within the set of
selected key indicators that it monitors and studies
cl osely. Thi s deci si on was made i n recogni ti on of
the fact that monetary growth and i nf l ati on are
closely related in the medium to long run (see also
Secti on 4. 5). Thi s wi dely accepted rel ati onshi p
provi des monetary pol i cy wi th a fi rm and rel i abl e
nominal anchor beyond the horizons conventionally
adopted to construct i nf l ati on forecasts.
Therefore, assigning money a prominent role in the
strategy was al so a tool used to underpi n i ts
medi um-term ori entati on. I ndeed, taki ng pol i cy
deci si ons and eval uati ng thei r consequences
not only on the basis of the short-term indications
stemmi ng f rom the anal ysi s of economi c and
f i nanci al condi ti ons, but al so on the basi s of
monetary and l i qui di ty consi derati ons al l ows a
central bank to see beyond the transient impact of
the vari ous shocks and not to be tempted to take
an overly acti vi st course.
POL I CY
BOX 5. 8 MONETARY AGGREGATES
Given that many different financial assets are close substitutes,
and that the nature and characteri sti cs of financial assets,
transactions and means of payment are changi ng over ti me, i t i s
not always cl ear how money shoul d be defi ned and whi ch
f i nanci al assets bel ong to whi ch def i ni ti on of money. Central
banks usually define and monitor several monetary aggregates.
The ECBs definitions of euro area monetary aggregates are based
on harmonised definitions of the money-issuing sector and the
money-hol di ng sector, as wel l as of categori es of monetary
fi nanci al i nsti tuti on (MFI) l i abi l i ti es. The money-i ssui ng sector
compri ses MFI s resi dent i n the euro area. The money-hol di ng
sector includes all non-MFIs resident in the euro area, excluding
the central government sector.
Based on conceptual consi derati ons and empi ri cal studi es, and
i n line with international practice, the Eurosystem has defined a
narrow (M1), an i ntermedi ate (M2) and a broad monetary
aggregate (M3). These aggregates di ffer wi th regard to the
degree of l i qui di ty of the assets they i ncl ude.
M1 i ncl udes currency, i . e. banknotes and coi ns, as wel l as
bal ances that can i mmedi ately be converted i nto currency or
used for cashl ess payments, such as overni ght deposi ts.
M2 compri ses M1 and, i n addi ti on, deposi ts wi th an agreed
maturity of up to two years or redeemable at a period of notice
of up to three months. These deposi ts can be converted i nto
components of narrow money, but some restrictions may apply,
such as the need for advance noti f i cati on, penal ti es and fees.
M3 comprises M2 and certain marketable instruments issued by
the resi dent MFI sector. These marketabl e i nstruments are
repurchase agreements, money market fund shares/units and debt
securi ti es wi th a maturi ty of up to two years (i ncl udi ng money
market paper). A high degree of liquidity and price certainty make
these instruments close substitutes for deposits. As a result of
thei r i ncl usi on, broad money i s l ess af fected by substi tuti on
between various liquid asset categories than narrower definitions
of money, and i s more stabl e.
Hol di ngs by euro area resi dents of l i qui d assets denomi nated
i n f orei gn currenci es can be cl ose substi tutes f or euro-
denomi nated assets. Theref ore, the monetar y aggregates
i ncl ude such assets i f they are hel d wi th MFI s l ocated i n the
euro area.
68
The prominent role assigned to money in the ECBs
strategy i s si gnal l ed by the announcement of a
ref erence val ue f or the growth of the broad
monetary aggregate M3. The choice of M3 is based
on the evi dence, supported by several empi ri cal
studi es, that thi s aggregate possesses the desi red
properti es of a stabl e money demand and l eadi ng
indicator properties for future price developments
in the euro area. The reference value for the growth
of M3 has been derived so as to be consistent with
the achi evement of pri ce stabi l i ty. Substanti al or
prolonged deviations of monetary growth from the
reference value would, under normal circumstances,
signal risks to price stability over the medium term.
The deri vati on of the reference val ue i s based on
the rel ati onshi p between (changes i n) monetary
growth (M), i nf l ati on (P), real GDP growth
(YR) and velocity (V). According to this identity,
whi ch i s wi dely known as the quanti ty equati on,
the change in money in an economy equals the
change in nominal transacti ons (approxi mated by
the change in real GDP plus the change in inflation)
minus the change in velocity (see also Box 4.3). The
l atter vari abl e can be defi ned as the speed wi th
whi ch money i s transf erred between di f ferent
money holders, and thus determines how much
money i s requi red to servi ce a parti cul ar l evel of
nomi nal transacti ons.
M = YR + P V
The reference val ue embodi es the def i ni ti on of
pri ce stabi l i ty as an i ncrease i n the HI CP for the
euro area of bel ow 2 % per annum. Furthermore,
the deri vati on of the reference val ue has been
based on medi um-term assumpti ons regardi ng
potenti al output growth and the trend i n the
vel oci t y of ci rcul at i on of M3. I n 1998 an
assumpti on of 2 % 2 % per annum was made for
the medi um-term trend i n real potenti al GDP
growth for the euro area, reflecting estimates from
both i nternati onal organi sati ons and the ECB.
Vari ous approaches were empl oyed to deri ve the
assumpti on for vel oci ty of ci rcul ati on, taki ng i nto
account si mpl e (uni vari ate) trends as wel l as
i nformati on avai l abl e f rom more compl ex money
demand model s. Taken together, the resul ts of
these approaches poi nted to a decl i ne of M3
vel oci ty i n the range of % 1 % per annum. On
the basis of these assumptions, the ECBs reference
value was set at 4 % per annum by the Governing
Counci l i n December 1998, and has not changed
since. The Governing Council monitors the validity
of the condi ti ons and assumpti ons underlyi ng the
reference value, and communicates any changes to
the underlying assumptions as soon as they become
necessary.
The reference value for monetary growth
In order to signal its commitment to monetary
anal ysi s and to provi de a benchmark f or the
assessment of monetary devel opments, the ECB
announced a reference value for the broad monetary
aggregate M3 (see Box 5. 9).
T HE ECB S MONETARY
BOX 5. 9 THE ECB S REFERENCE VALUE FOR MONETARY GROWTH
69
This reference value (which was set to a value of
4 % i n 1998) refers to the annual rate of M3
growth that is deemed to be compatible with price
stability over the medium term. The reference value
therefore represents a benchmark for analysing the
information content of monetary devel opments i n
the euro area. Owi ng to the medi um to l ong-term
nature of the monetary perspective, however, there
i s no di rect l i nk between short-term monetary
devel opments and monetar y pol i cy deci si ons.
Monet ar y pol i cy does not , t heref ore, react
mechani cal ly to devi ati ons of M3 growth from the
reference val ue.
Analysis of special factors
One reason for thi s i s that, at ti mes, monetary
devel opments may al so be i nfl uenced by speci al
f actors caused by institutional changes, such as
modi fi cati ons to the tax treatment of i nterest
i ncome or capi tal gai ns. These speci al f actors can
cause changes in money holdings, since households
and f i rms wi l l res pond t o changes i n t he
attractiveness of bank deposits included in the
definition of the monetary aggregate M3 relative to
alternative financial instruments. However, monetary
devel opments caused by these speci al factors may
not be very i nformati ve about l onger-term pri ce
devel opments. Consequently, monetary analysi s at
the ECB tri es to focus on underlyi ng monetary
trends by including a detailed assessment of special
factors and other shocks influencing money demand.
CROS S- CHECKI NG I NFORMATI ON
FROM THE TWO PI LLARS
Regarding the Governing Councils decisions on the
appropriate stance of monetary policy, the two-pillar
approach provides a cross-check of the indications
that stem from the shorter-term economic analysis
with those from the longer-term oriented monetary
analysi s. As expl ai ned i n more detai l above, thi s
cross-check ensures that monetary policy does not
overl ook i mpor t ant i nf ormat i on rel evant f or
assessing future price trends. All complementarities
between the two pillars are exploited, as this is the
best way to ensure that all the relevant information
for assessing price prospects is used in a consistent
and efficient manner, facilitating both the decision-
maki ng process and i ts communi cati on (see the
chart below). This approach reduces the risk of policy
error caused by the over-rel i ance on a si ngl e
indicator, forecast or model. By taking a diversified
approach t o t he i nt erpret at i on of economi c
condi ti ons, the ECBs strategy ai ms at adopti ng a
robust monetary policy in an uncertain environment.
5
POL I CY
PRIMARY OBJECTIVE OF PRICE STABILITY
FULL SET OF INFORMATION
Monetary
analysis
Economic
analysis
Governing Council takes
monetary policy decisions based
on an overall assessment of the
risks to price stability
Analysis of
economic shocks
and dynamics
Analysis of
monetary
trends
cross-
checking
CHART THE STABI LI TY- ORI ENTED MONETARY POLI CY STRATEGY
OF THE ECB
Source: European Central Bank (2004), The monetary policy of the ECB, p. 66.
70
TRANSPARENCY AND ACCOUNTABI LI TY
Reporting requirements imposed by the
Treaty
To mai ntai n i ts credi bi l i ty, an i ndependent central
bank must be open and cl ear about the reasons
for i ts acti ons. I t must al so be accountabl e to
democrati c i nsti tuti ons. Wi thout encroachi ng on
the ECBs independence, the Treaty establishing the
European Communi ty i mposes preci se reporti ng
obl i gati ons on the ECB.
The ECB has to draw up an Annual Report on i ts
acti vi ti es and on the monetar y pol i cy of the
previ ous and current year, and present i t to the
European Parliament, the EU Council, the European
Commi ssi on and t he European Counci l . The
European Parl i ament may then hol d a general
debate on the Annual Report of the ECB. The
Presi dent of the ECB and the other members of
the Executi ve Board may, at the request of the
European Parl i ament or on thei r own i ni ti ati ve,
present thei r vi ews to the competent commi ttees
of the European Parliament. Such hearings generally
take pl ace each quarter.
Furthermore, the ECB must publish reports on the
acti vi ti es of the ESCB at l east once every quarter.
Fi nal ly, the ECB has to publ i sh a consol i dated
weekl y f i nanci al statement of the Eurosystem,
whi ch ref l ect s t he monet ar y and f i nanci al
t r ans act i ons of t he Euros ys t em dur i ng t he
precedi ng week.
Communication activities of the ECB
In f act, the ECB has commi tted i tsel f to goi ng
beyond the reporti ng requi rements speci f i ed i n
t he Treat y. One exampl e of t hi s f ar- reachi ng
commi tment i s that the Presi dent expl ai ns the
reasoning behind the Governing Councils decisions
i n a press conference whi ch i s hel d i mmedi ately
after the f i rst meeti ng of the Governi ng Counci l
every month. Further detai l s of the Governi ng
Councils views on the economic situation and the
outl ook for pri ce devel opments are publ i shed i n
the ECBs Monthly Bul l eti n.
12
Relationship with EU bodies
A member of the European Commi ssi on has the
right to take part in the meetings of the Governing
Council and the General Counci l , but not to vote.
As a rul e, the Commi ssi on i s represented by the
Commi ssi oner responsi bl e f or economi c and
f i nanci al matters.
The ECB has a reciprocal relationship with the EU
Council. On the one hand, the President of the EU
Council is invited to the meetings of the Governing
Counci l and the General Counci l of the ECB. He
may put forward a moti on to be di scussed i n the
Governing Council, but may not vote. On the other
hand, the Presi dent of the ECB i s i nvi ted to the
meeti ngs of the EU Counci l when the Counci l i s
di scussi ng matters rel ati ng to the obj ecti ves and
tasks of the ESCB. Apart from the offi ci al and
informal meeti ngs of the ECOFI N Counci l (whi ch
bri ngs together the EU mi ni sters for economi c
aff ai rs and f i nance), the Presi dent al so takes part
i n meeti ngs of the Eurogroup (meeti ngs of the
mi ni sters for economi c af f ai rs and f i nance i n the
euro area countri es).
T HE ECB S MONETARY
12 The publications of the ECB are available free of charge
on request and may also be viewed on the ECBs website
(www.ecb.europa.eu), which also provides links to the websites
of the EU national central banks.
71
The ECB is also represented on the Economic and
Fi nanci al Commi ttee, a consul tati ve Communi ty
body whi ch deal s wi th a broad range of European
economi c pol i cy i ssues.
OVERVI EW OF THE EUROSYS TEM S
OPERATI ONAL FRAMEWORK
Operational framework
As menti oned bef ore, the Governi ng Counci l
decides on the level of key ECB interest rates. For
these interest rates to feed through to firms and
consumers, the ECB relies on the intermediation of
the banki ng system. When the ECB changes the
condi ti ons at whi ch i t borrows from and l ends to
the banks, the conditions set by the banks for their
customers, i.e. fi rms and consumers, are al so l i kely
to change. The set of Eurosystem i nstruments
and procedures for transacti ng wi th the banki ng
system, thereby i ni ti ati ng the process by which
these conditions are transmitted to households and
fi rms, i s cal l ed the operati onal framework.
Main categories of instruments
Broadly speaki ng, the euro area banki ng system
partly due to its need for banknotes but partly also
because the ECB asks i t to hol d some mi ni mum
reserves on accounts wi th the NCBs has a need
for l i qui di ty and i s rel i ant on refi nanci ng from the
Eurosystem. In thi s context, the Eurosystem acts
as l i qui di ty suppl i er and vi a i ts operati onal
framework helps the banks to meet their liquidity
needs i n a smooth and wel l -organi sed manner.
The operati onal f ramework of the Eurosystem
compri ses three mai n el ements. Fi rst, the ECB
manages reserve condi ti ons i n the money market
and steers money market interest rates by providing
reserves to the banks to meet their liquidity needs
through open market operati ons. Second, two
standi ng faci l i ti es, a margi nal l endi ng faci l i ty and a
deposi t f aci l i ty, are offered to banks to al l ow
overni ght l oans or deposi t s i n except i onal
ci rcumstances. The faci l i ti es are avai l abl e to banks
as and when they requi re, al though borrowi ng at
the marginal lending facility must be against eligible
collateral. Third, reserve requirements increase the
liquidity needs of banks. In addition, since they can
be averaged over a peri od of one month, they can
al so act as a buf fer agai nst temporary l i qui di ty
shocks i n the money market and thereby reduce
the vol ati l i ty of short-term i nterest rates.
Open market operations
Open market operati ons the f i rst el ement of
the operati onal f ramework are conducted i n a
decentral i sed manner. Whi l e the ECB coordi nates
the operations, the transactions are carried out by
the NCBs. The weekly main refinancing operation is
a key el ement i n the i mpl ementati on of the ECBs
monetary pol i cy. The of f i ci al i nterest rate set for
these operations signals the stance of the monetary
pol i cy deci ded by the Governi ng Counci l of the
ECB. The l onger-term ref i nanci ng operati ons are
al so l i qui di t y- provi di ng t ransact i ons, but are
conducted monthly and have a maturi ty of three
months. Fine-tuning operations are executed on an
ad hoc basi s to smooth the ef fects on i nterest
rates of unexpected l i qui di ty f l uctuati ons or
extraordi nary events.
5.4
5
The ECB has committed
itself to going beyond the
reporting requirements
specified in the Treaty.
POL I CY
When the ECB changes its
conditions for banks, the
conditions for firms and
consumers are also likely
to change.
72
The cri teri a for counterparty el i gi bi l i ty i n the
Eurosystems operations are very broad: in principle,
al l credi t i nsti tuti ons l ocated i n the euro area are
potentially eligible. Any bank may choose to become
a counterparty i f i t i s subj ect to the Eurosystems
reserve requirements, is financially sound, and fulfils
specific operational criteria enabling it to transact
with the Eurosystem. Both the broad counterparty
cri teri a and the decentral i sed operati ons are
f ormul ated to ensure equal treatment f or al l
i nsti tuti ons across the euro area so they may
parti ci pate i n the operati ons carri ed out by the
Eurosystem and are conduci ve to an i ntegrated
pri mary money market.
The open market operations of the Eurosystem are
conducted as repurchase agreements (repos) or
as col l ateral i sed l oans. In both cases, short-term
l oans from the Eurosystem are granted agai nst
sufficient collateral. The range of eligible collateral
in the operations is very wide, including public and
private sector debt securities, to ensure an abundant
collateral base for counterparties across euro area
countri es. Moreover, el i gi bl e assets can be used
across borders. The open market operations of the
Eurosystem are organi sed as aucti ons to ensure a
transparent and efficient distribution of liquidity in
the pri mary market.
An overriding feature of the operational framework
is the reliance on a self-regulating market, with the
infrequent presence of the central bank. The money
market interventions of the central bank are generally
l i mi ted to the mai n refi nanci ng operati ons whi ch
take pl ace once a week, and the much smal l er
longer-term refinancing operations which take place
once a month. Fi ne-tuni ng operati ons have been
rather i nfrequent i n the fi rst years of the ECB.
Standing facilities and reserve requirements
The two maj or i nstruments compl ementi ng the
open market operations the standing facilities and
the reserve requi rements are appl i ed mai nly to
contain volatility in short-term money market rates.
The rates on the standi ng faci l i ti es are usual ly
significantly less attractive than the interbank market
rates (+/

one percentage poi nt from the mai n

ref i nanci ng rate). Thi s gi ves banks an i mportant
i ncenti ve to transact i n the market and only use
standi ng faci l i ti es when other market al ternati ves
have been exhausted. Si nce banks al ways have
access to standi ng f aci l i ti es, the rates on the two
standi ng f aci l i ti es provi de a cei l i ng and a f l oor by
market arbitrage for the overnight market interest
rate (the so-cal l ed EONI A). The two rates
therefore determi ne the corri dor i n whi ch the
EONIA can fl uctuate. In thi s context, the wi dth of
the corri dor shoul d encourage the use of the
market. Thi s adds an i mportant structure to the
money market whi ch l i mi ts the vol ati l i ty of very
short-term market rates (see the chart bel ow).
A banks reserve requi rements are determi ned as
a fraction of its reserve base, a set of liabilities on
i ts bal ance sheet (deposi ts, debt securi ti es and
money market papers wi th a maturi ty of l ess than
two years).
T HE ECB S MONETARY
73
The reserve requi rement system speci fi es banks
required minimum current account holdings with
their NCB. Compliance is determined on the basis
of the average of the daily balances over a period of
around one mont h ( cal l ed t he mai nt enance
period). The averaging mechanism provides inter-
temporal fl exi bi l i ty to banks i n terms of managi ng
reserves across the reserve mai ntenance peri od.
Temporary l i qui di ty i mbal ances do not need to be
covered i mmedi atel y and, consequentl y, some
vol ati l i ty i n the overni ght i nterest rate can be
smoothed out. (If, for i nstance, the overni ght rate
is higher than the expected rate later in the reserve
mai ntenance peri od, banks can make an expected
prof i t from l endi ng i n the market and postponi ng
the fulfilment of required reserve holdings until later
i n the peri od (i nter-temporal substi tuti on). Thi s
adjustment of the dai ly demand for reserves hel ps
to stabi l i se i nterest rates. )
The holdings of required reserves are remunerated
at the average tender rate i n the mai n refi nanci ng
operations over a maintenance period. This rate is
virtually i denti cal to the average i nterbank market
rate at the same maturi ty. Reserves hel d at the
banks current accounts i n excess of the monthly
requirement are not remunerated. This gives banks
an i ncenti ve to manage thei r reserves acti vely i n
the market. At the same time, the remuneration of
requi red reserves avoi ds the ri sk of the reserve
requirement being a burden on banks or hampering
the effi ci ent al l ocati on of f i nanci al resources.
The requi red reserves act as a buf fer agai nst
l i qui di ty shocks. Fl uctuati ons i n reserves around
the requi red l evel can absorb l i qui di ty shocks
wi t h l i t t l e i mpact on market i nt erest rat es.
Therefore, there i s l i ttl e need for extraordi nary
i nterventi on by the central bank i n the money
market to stabi l i se market rates.
5
A major feature of the
framework is the reliance
on a self-regulating market,
with the infrequent presence
of the central bank.
overnight interest rate (EONIA)
marginal lending rate
main refnancing rate/minimum bid rate
deposit rate
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
0.0
1.0
2.0
3.0
4.0
5.0
6.0
overnight interest rate (EONIA)
main refnancing rate/minimum bid rate
marginal lending rate
deposit rate
CHART ECB I NTEREST RATES AND MONEY MARKET RATES
Source: ECB. Last observation: 16 June 2009.
POL I CY
74
GLOS S ARY
Barter
The mutual exchange of goods and servi ces for
other goods and servi ces wi thout usi ng money as
a medi um of exchange. It general ly requi res a
mutual need for the i tems bei ng traded.
Consumer Price Index
Compi l ed once a month usi ng what i s cal l ed a
s hoppi ng bas ket . For t he euro area, t he
Harmoni sed Index of Consumer Pri ces (HI CP) i s
used, wi th a stati sti cal methodol ogy that has been
harmoni sed across countri es.
Deflation
A sustai ned decl i ne i n the general pri ce l evel , e. g.
i n the consumer pri ce i ndex, over an extended
peri od.
Euro area
The area that is made up of those Member States of
the European Uni on i n whi ch the euro has been
adopted as the si ngl e currency.
European Central Bank (ECB)
Established on 1 June 1998 and located in Frankfurt
am Mai n, Germany. The ECB i s at the heart of the
Eurosystem.
European System of Central Banks (ESCB)
The ECB and the NCBs of al l EU Member States,
regardl ess of whether or not they have adopted
the euro.
Eurosystem
The ECB and the NCBs of those Member States
that have al ready adopted the euro.
Executive Board
One of the deci si on-maki ng bodi es of the ECB.
I t compri ses the Presi dent and the Vi ce-Presi dent
of the ECB and four other members appoi nted by
common accord by t he Heads of St at e or
Government of the Member States that have
adopted the euro.
General Council
One of the deci si on-maki ng bodi es of the ECB.
I t compri ses the Presi dent and the Vi ce-Presi dent
of the ECB and the governors of al l EU NCBs.
Governing Council
The supreme deci si on-maki ng body of the ECB.
I t compri ses al l the members of the Executi ve
Board of the ECB and the governors of the NCBs
of the countri es that have adopted the euro.
75
Inflation
An i ncrease i n the general pri ce l evel , e. g. i n the
consumer pri ce i ndex, over an extended peri od.
Interest rate
The percentage of extra money you get back if you
lend your money to someone else (or keep it in the
bank) or the percentage of extra money you have
to pay back i f you borrow money (i n addi ti on to
the l oan recei ved).
Monetary base
In the euro area, it consists of currency (banknotes
and coi ns) i n ci rcul ati on, the reserves hel d by
counterparties with the Eurosystem and the funds
deposi ted wi th the Eurosystems deposi t faci l i ty.
These i tems are l i abi l i ti es on the Eurosystems
bal ance sheet. Reser ves can be broken down
further i nto requi red and excess reserves. In the
Eurosyst ems mi ni mum reser ve syst em
count erpar t i es are obl i ged t o hol d requi red
reserves wi th the NCBs. I n addi ti on to these
requi red reserves, credi t i nsti tuti ons usual ly hol d
only a smal l amount of vol untary excess reserves
wi th the Eurosystem.
Monetary policy strategy
The general approach to the conduct of monetary
policy. The key features of the monetary policy
strategy of the ECB are a quantitative definition
of the primary objective of price stability and an
anal yti cal f ramework based on t wo pi l l ars
economi c anal ys i s and monet ar y anal ys i s .
Moreover, the strategy i ncl udes general principles
for the conduct of monetary policy, such as the
medi um-term ori entati on. The strategy forms the
basis of the Governing Councils overall assessment
of the ri sks to pri ce stabi l i ty and of i ts monetary
policy decisions. It also provides the framework for
explaining monetary policy decisions to the public.
Monetary policy transmission mechanism
The process t hrough whi ch monet ar y pol i cy
deci si ons af fect the economy i n general and the
pri ce l evel i n parti cul ar.
Price stability
Maintaining price stability is the primary objective of
the Eurosystem. The Governing Council of the ECB
has defined price stability as a year-on-year increase
i n the HICP for the euro area of bel ow 2 %. It has
further cl ari fi ed that wi thi n thi s defi ni ti on i t ai ms
to mai ntai n the annual i nf l ati on rate at bel ow but
cl ose to 2 % over the medi um term.
76
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78
European Central Bank, 2011
Address Kaiserstrasse 29,
60311 Frankfurt am Main, Germany
Postal address Postfach 16 03 19,
60066 Frankfurt am Main, Germany
Telephone +49 69 1344-0
Fax +49 69 1344-6000
Website http://www.ecb.europa.eu
Author Dieter Gerdesmeier
Design Alexander Weiler, Visuelle Kommunikation,
Hnstetten, Germany
Photo credits Andreas Pangerl, Corbis, European Central Bank,
Image Source, Jane M. Sawyer, Photos.com
All rights reserved.
Reproduction for educational and non-commercial purposes
is permitted provided that the source is acknowledged.
ISBN (online) 978-92-899-0690-6
EN