The Eurosystem’s primary objective is price stability.
Money is a means of exchange that can be used to buy things. However, whether the banknotes and coins in your wallet or the balance on your bank account are worth a little or a lot does not actually depend on the amounts themselves. The value of money is measured solely by how many goods and services you can purchase for a given amount. The value of money therefore lies in its purchasing power, which, in turn, depends on prices. The higher the prices, the lower the purchasing power of a given amount of money. The Eurosystem has the statutory mandate of maintaining price stability and thus preserving the purchasing power of money.
(1) The primary objective of the European System of Central Banks (hereinafter referred to as “the ESCB”) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union (…). The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources (…).
The monetary policy objective of maintaining price stability is not about the stability of individual prices. Instead, the aim is merely for prices to remain stable on average. This means that price increases for some goods balance out price decreases for others so that the price level in the economy as a whole does not change and purchasing power thus remains intact.
In a market economy, prices must be flexible.
For a market economy to function smoothly, prices for goods and services must be flexible. Only then do they indicate the scarcity of goods (signalling function) and balance out supply and demand (market-clearing function).
When making purchasing decisions, most customers pay attention to the quality, appearance and functionality of the desired goods. However, the price is often just as important. As a rule, the cheaper the product, the greater the demand – as demonstrated by the effect of special offers, for example. It can therefore be said that if the price of a product falls, demand usually rises, as long as all other conditions remain the same. Conversely, if the price rises, demand falls accordingly.
What is true for the demand side also applies to the supply side – just in the opposite direction: if the price rises, the supplied amount usually does too. Existing suppliers will increase production when selling prices increase. At the same time, new suppliers enter the market over the medium term. However, if the price falls, it is no longer as lucrative to produce the goods in question; thus, supply decreases as well. Some less competitive suppliers will actually stop selling these now unprofitable goods entirely.
Flexible prices ensure a balance between supply and demand.
The “price mechanism” ensures a balance between the amount supplied and the amount in demand, provided that prices can move freely. The price will stabilise at the level where demand for a given good corresponds exactly to its supply. Independent price formation creates a balance between supply and demand.
We talk of “price stability” when the price level only changes a little over time, even if individual prices rise or fall.
Price stability: the price level should remain stable.
An increase in the price level is called inflation (from the Latin “inflare”, meaning “blow into”, “puff up”). The percentage increase in the price level between two points in time is called the rate of inflation or the rate of price increase. It is usually reported on an annual basis and thus reflects the change compared with the situation 12 months earlier. For example, if the newspaper states that the rate of inflation was 1.4% in January 2019, this means that the price level was 1.4% higher in January 2019 than it was in January 2018.
The opposite process, i.e. a decrease in the price level, is called deflation. The percentage decrease in the price level between two points in time is therefore referred to as the rate of price reduction or rate of deflation. However, it is often referred to – paradoxically, in fact – as a negative rate of price increase or a negative rate of inflation. According to the definition relevant for economics, however, deflation only prevails if the price level falls not just briefly but over a longer period of time.
IIf a positive inflation rate declines over time – for example, it falls from 1.8% to 1.6% and then to 1.3% – but stays positive, it is referred to as a falling inflation rate, declining inflation, or “disinflation”.
When the price level rises, the value of money falls. In other words, the purchasing power of money decreases as the price level rises because fewer goods and services can be purchased for a given amount of money than before. It can also be said that real monetary value, i.e. monetary value measured in units of goods, declines as a result of inflation. Viewed over a longer period, the loss in purchasing power can be considerable, even if the inflation rate may seem fairly low at first glance. As illustrated by the chart, at an annual inflation rate of 4%, €100 ten years from now would only have the purchasing power of just under €68 today. After 50 years, you would only be able to purchase goods worth the equivalent of €14 today.
In the shorter term, changes in the price level are due to aggregate demand and supply. If aggregate demand increases, this generates price pressures, i.e. inflation, if all other conditions in the economy remain unchanged. This is called demand-driven inflation.
In the shorter term, inflation is determined by supply and demand.
There may be a number of reasons for this. For example, enterprises could be more confident about the future, discover new business opportunities and, accordingly, increase their investment in machinery and equipment or in research and development. Enterprises’ increased demand for investment might also be motivated by lower interest rates, which make loan-funded investments cheaper, and thus more likely, than when interest rates are higher. Households, too, often base their spending on changes in their financing conditions. If interest rates fall, household demand generally also increases. This connection is particularly relevant for the economy if falling interest rates lead to an increase in demand for higher-priced durable goods, such as kitchens or cars. Large amounts of money are usually needed to finance these purchases and are often obtained through loans. Another possibility is that an increase in aggregate demand may be due to higher government demand for consumption and investment purposes or to rising foreign demand (exports).
However, if aggregate demand declines, the opposite holds true. Falling demand tends to lead to reduced price pressures and thus also to falling inflation or, in rare, extreme cases, to persistent, crisis-like deflation.
Changes on the supply side also have an impact on the price level. Since these supply-side changes are usually associated with cost changes, this is called cost-push inflation. One example would be higher production costs as a result of rising energy prices because energy is needed to produce almost every good in an economy. Wages are also an important cost component for enterprises. Suppliers will usually try to pass on their increasing costs to consumers. Higher production costs are therefore often followed by rising prices for consumers, leading to cost-push inflation.
Over the longer term, inflation is always a monetary phenomenon.
In the long term, a growing supply of money has an impact on price developments. This is because a sustained rise in aggregate prices can only occur if the increase in prices is “financed” by a corresponding increase in money. While not every excessive increase in the money supply necessarily leads to higher inflation, persistently higher inflation always goes hand in hand with excessive growth in the money supply. Thus, one decades-old economic principle is that, in the long run, inflation is ultimately always a monetary phenomenon (from the Latin “moneta”, meaning “mint”, “minted money”). In the long term, inflation is therefore always connected with money and the development of the money supply – a principle that is borne out by many academic studies.
A period in which inflation is already very high, yet keeps rising until it eventually spirals out of control, is called hyperinflation. Hyperinflation generally spells the end of the monetary system. In such a period, money loses its functions, no longer serves as a means of payment, unit of account or store of value, and is no longer accepted by most people. Although there is no universally accepted definition, inflation rates of more than 50% per month are considered signs of hyperinflation. A monthly inflation rate of 50% means that over the course of a year prices rise to more than one hundred times their original level, with money thus losing more than 99% of its purchasing power.
In 1923, Germany suffered hyperinflation , and this became the formative experience of an entire generation. This followed on from the First World War, when the government instructed the Reichsbank to grant it unlimited credit, enabling it to finance around one-third of the war’s costs by printing money. The volume of banknotes in circulation consequently rose from 2.6 billion to 22.2 billion Mark between 1914 and 1918. The Mark lost value and prices rose. After the war, the Weimar Republic continued this borrowing policy, financing around three-quarters of its expenditure by selling debt securities to the Reichsbank. The money supply grew ever larger. At the same time, the Mark lost its purchasing power. By mid-November 1923, at the height of hyperinflation, the price of a loaf of bread had gone up to more than 230 billion Mark. During hyperinflation, prices rose faster than the Reichsbank could print new banknotes. As a result, cities, local governments and firms began producing emergency money (“Notgeld”) – sometimes with the Reichsbank’s approval, sometimes without. When hyperinflation ended in November 1923, 496 quintillion Reichsmark were circulating as banknotes and 727 quintillion Reichsmark as Notgeld banknotes.
To put an end to inflation, the German government carried out a currency reform in November 1923. Rentenmark banknotes were issued by the Rentenbank, which was established specifically for this purpose. The total volume was limited to 3.2 billion Rentenmark. From 20 November 1923, people could exchange the inflated Mark for Rentenmark at a rate of one trillion to one. The Rentenmark was kept stable by a monetary policy that was strictly oriented towards preserving the value of money as well as fiscal consolidation.
However, hyperinflation is not just a phenomenon from the distant past. It can happen again at any time, even today. In November 2008, for example, Zimbabwe experienced a period in which prices doubled every 24.7 hours. The government printed banknotes in larger and larger denominations (up to a value of 100 trillion Zimbabwean dollar) before being forced to abandon the Zimbabwean dollar in February 2009. In Venezuela, too, the currency has been depreciating at an increasingly rapid pace for a few years now. In autumn 2018, the International Monetary Fund (IMF) expected the inflation rate in Venezuela to be 10 million percent in 2019.
Changes in the price level cannot be measured using individual prices.
Whether the price level and thus the purchasing power of money change cannot be measured using just a few prices. It is the average development of all prices in an economy that is important. However, it is virtually impossible to collect millions of individual prices for all goods and services. Therefore, price developments of a suitable selection of goods are used to determine the change in the price level.
Developments in the price level are determined using a basket of goods.
The German Federal Statistical Office (Destatis) determines which goods should be included in the representative “basket of goods” on the basis of a regular sample survey of income and expenditure. The basket comprises around 650 types of goods assigned to 12 categories of goods covering a wide range of goods and services that are typical of an average German household’s consumption behaviour. The content ranges from various items, such as food and clothing, housing rents and insurance premiums, as well as services, such as visits to the hairdresser, to infrequently purchased goods, such as cars and washing machines. It even covers things that are not everyday purchases for everyone, such as the prices for herbal tonic, a cable car ride and a fishing license.
The basket of goods is updated continuously in order to ensure that the price measurement always includes product variants that are currently relevant. Within a product category, the specific individual products for which prices are recorded (known as the price representatives) are therefore replaced regularly. All in all, every month the Federal Statistical Office records over 300,000 individual prices at retailers, in catalogues and on the internet. The relevant factors when measuring prices are acquisition costs including value added tax (VAT) and excise taxes.
This simplified example illustrates how a price index is calculated and how general price developments are measured. Assuming that a representative basket of annual household expenditure consists of 100 bars of chocolate, 50 bottles of apple juice, 10 visits to the cinema and one pair of shoes, the price index would be calculated using this basket of goods as shown in the table.
The price of the basket of goods is calculated by multiplying the quantity of each good by the respective price and adding the results together (expenditure total). If the basket of goods contains a large number of prices, it is no longer feasible to use the expenditure total; changes are instead indicated using the price index. To do this, the expenditure total of the first year (base year) is set to 100 (€300 equates to 100). This value serves as a reference figure for the following years. The inflation rate represents the relative price change compared with the previous year. As the example shows, the price index can also rise even though individual prices fall.
Changes in quantity are also taken into account when measuring prices.
The official price measurement takes into account not only the price shown but also any changes in quantities. This means that if the quantity of a supplied product has changed but the quality and price have remained the same, the statisticians carry out a quantity adjustment to ensure that the price is measured correctly. In other words, if, for example, the same product has the same price as before despite a reduced quantity (e.g. a smaller amount in each package), this is recorded as a “hidden” price increase. The price adjustment method described here is typically applied to food and other non-durable goods.
The Federal Statistical Office uses the prices of the goods in the basket to calculate the consumer price index (CPI) in Germany on a monthly basis. This measures the average change in the prices of all goods and services purchased by households for consumption purposes. The annual change in the consumer price index, i.e. compared with 12 months earlier, is expressed as a percentage and is called the inflation rate. The change in the CPI is the value to which journalists refer when talking about the inflation rate in Germany.
The higher the expenditure share, the greater the impact on the price index.
When calculating the consumer price index, the price changes of the individual types of goods are weighted differently. The higher the share of consumption expenditure that is accounted for by a particular category of goods, the more clearly the price index reflects the changes in their prices. The weighting scheme determines the respective expenditure shares and thus the weights of the individual product categories for the index calculation.
The basket of goods is constantly updated at the individual product level. By contrast, the Federal Statistical Office deliberately keeps the weighting scheme of a given base year constant for five years when calculating the consumer price index since the price index should only reflect price changes and not changes in spending habits. It would no longer be possible to identify price changes in isolation if the expenditure weights were also changed monthly in the official price measurement, i.e. if “purchasing behaviour” were to change continuously.
In the official price statistics, price changes should be measured such that they remain as unaffected as possible by changes in the quality of the goods or services. Thanks to technological advances, however, many products are constantly undergoing further development and, in many cases, being improved. Therefore, after a certain period of time, it is no longer possible to purchase many goods in their original form – advances in mobile phone technology over the past 20 years are a prime example. Should an updated product supersede a product previously included in the consumer price index, statisticians need to apply specialised quality adjustment methods so that they can evaluate the measured price change in a meaningful way.
Quality changes must be factored out for price measurement to be correct.
When it comes to correctly measuring inflation, quality changes are relevant for the following reasons. If the prices of monitored goods rise at the same time as their quality, it is necessary to distinguish between the “pure” price increase and the price increase attributable to the improved quality. In such cases, the price differential caused by the change in quality is estimated and factored out when calculating the consumer price index. In other words, if the price has only risen for quality reasons, this does not signify a loss of purchasing power, as consumers now also get “more for their money” than before with the new, improved product. Using quality adjustment procedures therefore ensures that, despite product changes, like is compared with like when prices are measured. In this way, the calculated price changes can then be interpreted as “pure” price developments and distinguished from quality-related price changes.
In the face of rapidly changing product quality, statisticians have developed a variety of methods to adjust measured price developments. Not all adjustment procedures are applied at the same time. Instead, statistical authorities draw on a suitable set of methods.
Quality adjustment can be achieved by identifying monetary benefits, for example. This means that, by including supplementary sources of information for some products, an evaluation can be made of the specific additional benefits – measured in financial terms – that a new product model offers to consumers. Typical cases for these additional benefits are the increasing efficiency of technical devices and appliances. Taking the example of a new washing machine, statisticians factor the monetary benefit from the lower electricity and water consumption out of the price of the washing machine.
Another method of taking quality differentials into account is to use the prices paid for optional extras. Statisticians tend to use this adjustment procedure if a certain product feature was originally an optional extra but now comes as standard, such as park assist devices installed in cars, for example. In such cases, part of the amount that, according to the list price, would once have been paid for the optional extra is then recognised as the monetary value of the quality differential and thus factored out of the price change.
Particularly in the case of products that undergo significant changes within a short space of time (computers and smartphones, for example), what are known as “hedonic” methods are used for quality adjustment when measuring prices. The frequent price changes seen for such products are often also accompanied by product upgrades. Using hedonic methods, it is possible to calculate the impact of individual product features (such as storage capacity or processing power) on product prices. This makes it possible to calculate the monetary value of the quality differential between the old and new models, distinguishing it from the “pure” change in price.
The primary objective of the Eurosystem’s monetary policy is to maintain price stability in the euro area. A metric is therefore required to measure price developments across the entire euro area. The Harmonised Index of Consumer Prices (HICP) fulfils this function. To calculate this index, every euro area country calculates an additional, special consumer price index, using a harmonised method, in addition to the respective national measures of inflation. In Germany, the value usually differs from the consumer price index (CPI) by only one or two tenths of a percentage point.
The HICP is the main barometer for price stability in the euro area.
The individual euro area countries then report their monthly results to the Statistical Office of the European Union (Eurostat). This means that it is neither the Governing Council of the European Central Bank (ECB) nor the Eurosystem that ascertains price developments, but Eurostat, the European statistical authority, which is independent from monetary policy. Eurostat then uses the national inflation data it receives to calculate the HICP for the entire euro area. The rates of change represent the inflation rate in the euro area. The HICP thus also acts as the public’s yardstick for assessing whether the Eurosystem is succeeding in maintaining price stability and thus fulfilling its statutory mandate.
The aggregation of HICP country data takes into account the share of each country in overall consumer spending in the euro area. This means that national inflation data are incorporated into the euro area’s HICP with different weights.
Since the introduction of the euro, annual inflation in the euro area has fluctuated from one year to the next. In 2008, inflation was driven up by higher energy prices, in particular, but just one year later the slump in global economic activity caused by the financial crisis led to a sharp decline in inflationary pressure. The price level even declined in the second half of 2009 for a short period of time.
In the years after 2012, falling energy prices were the main factor behind the clear decline in the inflation rate in the euro area. Added to this was the economic crisis in some euro area countries, which likewise considerably dampened price pressures. In 2015 and 2016, the rate of inflation was only 0.2%, meaning that the price level in the euro area remained virtually unchanged on the previous year. Inflation rates have seen slight rises since then, partly owing to the economic recovery and rising energy prices.
The inflation rates of the individual Member States often differ from the euro area average. Amongst other things, these deviations reflect the fact that economic developments vary across the individual countries. For example, whilst one country is experiencing an economic upswing with falling unemployment and higher wage and price pressures, another country may see a deterioration in economic developments with rising unemployment and declining inflation.
Price stability is key in both economic and social terms.
In the longer term, price stability is a fundamental prerequisite for the smooth functioning of a market economy, for sustained economic growth, and for preventing inflation from distorting income and wealth distribution. Stable money can also be seen as a specific social policy, as monetary stability protects “ordinary people”, in particular, from losses in wealth caused by inflation and thus a gradual process of dispossession.
If the price level remains broadly stable overall, it is easy to identify changes in relative prices, i.e. the prices of goods in relation to each other. Price movements then truly indicate whether a good has become scarcer or more abundant and whether there is higher or lower demand for it. These price signals are important for the production and spending decisions taken by enterprises and households. The rise and fall of goods prices steers scarce economic resources to wherever demand is high.
Stable money is important for the functioning of the price mechanism.
Inflation distorts the signalling and steering function of the price mechanism and thus disrupts the central steering mechanism of a market economy. Safeguarding price stability and thus helping to ensure that enterprises and households have planning certainty is therefore the best contribution monetary policy can make to sustainable economic growth and high employment levels.
Furthermore, when inflation rates are higher, lenders often demand premiums on their interest rates as compensation for uncertainty about the extent of future depreciation. In a broadly stable environment, however, this so-called inflation risk premium is low. Lower interest rates promote investment, economic growth and job creation.
Stable money safeguards the real value of income and savings, thereby helping to prevent redistribution of wealth. Experience has shown that inflation has an especially negative impact on poorer groups of the population. Recipients of fixed payments, such as pensioners or benefit recipients, are often at a particular disadvantage, as these payments are, for the most part, not regularly adjusted for depreciation.
Stable money protects savers who are often largely unable to avoid the consequences of inflation.
In addition, households with low income generally do not have significant non-financial assets, but merely savings. They are therefore largely unable to avoid the negative effects of inflation. In the event of unexpected price increases, savings deposits lose purchasing power. Interest rates on savings accounts tend to rise with inflation, but higher interest rates can often only be obtained by making new investments. If money is tied up for the long term at a fixed interest rate, savers lose out if inflation rates rise unexpectedly.
Inflation therefore makes it more difficult for broad sections of the population to build up wealth and also causes the purchasing power of private old-age provisions to diminish. This dampens the incentive to build up private savings for retirement, which can lead to an increase in old-age poverty in the long term and thus have a negative impact on society.
Inflation also puts taxpayers at a disadvantage, as they are subject to bracket creep. This means that in a tax system, such as the one in Germany, that taxes nominal variables (e.g. income), higher tax rates are also applied when income grows solely as a result of inflation, without an increase in real income. In other words, even if income just keeps up with inflation, the average tax burden increases as a result of bracket creep. The government therefore has more money at its disposal after price adjustment, while households and enterprises have less. This is also a situation that does not foster a country’s economic momentum in the long run.
The loss of purchasing power suffered by creditors in the event of unexpectedly high inflation is offset by the debtor’s gains in purchasing power. The latter tend to benefit because when inflation is higher, their nominal fixed liabilities decline in real terms, i.e. after adjustment for price increases. However, inflation often has negative repercussions for debtors, too. This is because, especially in times when inflation rates are soaring, incentives are created for higher borrowing in order to finance real assets such as real estate. Nevertheless, such a credit-financed “flight into real assets” is not ideal from either an individual or a macroeconomic perspective.
In the face of inflation fears, enterprises and households often make decisions that are not inherently rational in economic terms. Instead, these decisions are often primarily intended to evade the negative effects of inflation as far as possible, for example by investing in real estate, but not in purchasing new machinery to expand output. If price bubbles in the real estate market then burst, this might not only result in heavy losses for investors, but also give rise to a massive economic crisis.
Stable money ultimately benefits everyone.
We can therefore sum up as follows: persistent and rampant inflation attacks the foundations of the market economy on multiple fronts. It exacerbates conflicts over wealth distribution in society and leads to losses in growth and employment over the long run.
Deflation, i.e. a prolonged decline in prices, can also be detrimental to the economy as a whole. Similar to inflation, deflation also distorts the signalling function of prices and can lead to undesirable redistribution effects between creditors and debtors.
Deflation can also be detrimental to the economy as a whole.
We use the term “deflation” in the narrower, economically damaging sense to describe an economic crisis with a self-reinforcing spiral of falling prices and wages. At first glance, consumers and savers initially benefit from lower prices. However, this development can lead to consumer spending being delayed in anticipation of a further decline in prices. Firms may then be forced to cut production, leading to falling wages and job losses. In extreme cases, this can lead to a downward spiral in the economy as a whole, with cuts in prices and wages, shrinking output, and rising unemployment reinforcing each other.
Moreover, deflation can lead to a significant increase in the real debt burden of both enterprises and households, which can eventually even become overwhelming. While the prices of goods offered by enterprises are lower and wages tend to fall in periods of deflation, loan repayments remain unchanged. The real burden of existing repayment obligations is thus higher in an environment of generally falling prices. Such a development can lead to a higher number of insolvencies and an increase in non-performing loans on banks’ balance sheets. This, in turn, can jeopardise the stability of the financial system and put an additional strain on the economy.
The primary objective of the Eurosystem’s monetary policy is to maintain price stability. The ECB Governing Council defines price stability as an annual increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. However, price stability does not have to be maintained at all times (e.g. every month or every year) but over the medium term. The reason for this medium-term orientation is that monetary policy measures only affect price developments with a certain time lag. Ultimately, it is impossible to counteract undesirable price developments in the short term using the tools available to the central bank.
The public is given a yardstick for assessing monetary policy.
The chosen definition specifies that, for the euro area as a whole, persistent depreciation of 2% or more is incompatible with price stability. The same applies to deflation, i.e. a longer-lasting decline in the general price level. By communicating its definition of price stability openly and transparently, the ECB Governing Council also provides the public with a yardstick for assessing the success of its monetary policy.
In May 2003, following a review of its monetary policy strategy, the Governing Council specified that, in the pursuit of price stability, it aims to maintain HICP inflation below, but close to, 2%.
At first glance, it may seem surprising that the ECB Governing Council does not aim for a completely stable price level and thus an inflation rate of 0%. However, there are good reasons for the approach of targeting moderate inflation.
On the one hand, a slightly positive inflation rate counters any small statistical measurement errors when measuring prices, which could lead to measured inflation being somewhat higher than actual inflation. Aiming for an inflation rate of 0% would therefore harbour the risk that, once the measured rate has reached zero, the actual inflation rate would already be in negative territory, which is not intended.
A moderate rate of price increase therefore also offers a safety buffer against deflation. This is necessary because deflation can be just as harmful as inflation. However, it is more difficult to tackle deflation using monetary policy tools, which is why it is advisable not to let it happen in the first place. While the central bank can, in principle, raise its policy rate indefinitely to dampen the economy, it can, at best, lower the policy rate slightly below zero in order to stimulate the economy (see Chapter 6 for information on the monetary policy mechanism of the policy rate). If the central bank were to set the policy rate well below 0%, the interest rates on transferable savings and time deposits would probably also fall significantly below 0%. Investors would effectively have to pay a fee for their credit balances. In order to avoid this, they might begin to have large volumes of their bank deposits paid out in cash and store the money at home. This would run completely counter to monetary policymakers’ intention of encouraging households and enterprises to spend their money instead of hoarding it.
There are good reasons to aim for moderate inflation.
An average inflation rate in the euro area of just below 2% also ensures that individual euro area countries with inflation rates somewhat below the euro area average do not immediately drift into deflation. Aiming for an average inflation rate of 0% in the euro area would automatically mean that, if prices in some Member States were to rise, other countries would be forced to have negative inflation rates in order to reach an overall average of 0%.
Moreover, the Eurosystem’s monetary policy stance towards a moderate inflation rate of “below, but close to, 2%” also ties in with the Bundesbank’s historical experience and is in line with the current orientation of other central banks. The Bank of England and the US Federal Reserve, for example, also aim for inflation rates of 2%.
Since the introduction of the euro, annual inflation in the euro area has fluctuated to a greater or lesser degree from one year to the next. On average (calculated as the geometric mean), euro area inflation stood at 1.6% per year between 1999 and 2020. In terms of its avowed objective, the Eurosystem has thus been able to maintain price stability on average since the introduction of the single currency.