Lecture Notes: Price Stability

Definition of Price Stability

• Year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the Euro area below 2% (European Central Bank).
• Shopping Basket Analogy:
  • Contains a variety of products (bread, tomatoes, shoes, computers).
  • Regularly checked for price changes; stability means increases are under 2%.

Importance of Money

• Money simplifies trade and avoids the complications of bartering.
  • Example: A baker paying for a haircut with bread gets complicated if the hairdresser doesn't want it.
• Money hasn't always retained its value; historical periods of high inflation exist.

Understanding Inflation

• Inflation occurs when there is too much money and not enough goods, leading to price increases.
• Example scenario illustrates rising prices due to increased demand and costs of production.
• Negative effects of inflation:
  • Decreased purchasing power, particularly affecting the less well-off.
  • Inflation can be hard to control once it begins.

Role of the European Central Bank (ECB)

• The ECB aims to maintain price stability and keep inflation below but close to 2% over the medium term.
• Methods of Monitoring:
  1. Assess factors influencing short-term price fluctuations (economic growth, oil prices).
  2. Monitor money circulation in the economy (to prevent medium to long-term inflation).
• Historical correlation between high inflation and excess money supply.

Interest Rates and Their Impact

• ECB sets interest rates, which influence borrowing and spending behaviors.
  • Higher interest rates reduce demand for money, discouraging borrowing.
  • Lower interest rates encourage borrowing and spending.
• Stable prices build consumer and investor confidence, promoting economic growth and job creation.

Additional Concepts

• Deflation:
  • General decrease in prices, which can lead to negative economic behavior (postponing purchases, delayed investments).
  • Like inflation, deflation harms the economy.

Conclusion

• Primary objective of the ECB and Eurosystem is to maintain price stability and combat inflation.