Teacher's booklet - the Generation ?uro Students' Award

The objective
of price stability
The objective of price stability refers to the general level of
prices in the economy and implies avoiding prolonged
periods of both inflation and deflation.
The ECB defines its price stability objective as “a year-on-year
increase in the Harmonised Index of Consumer Prices (HICP)
for the euro area of below, but close to, 2% over the medium
term”.
Price stability contributes to achieving high levels of
economic activity and employment by:
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improving the transparency of the price mechanism. In
an environment of stable prices, it is easier for people to
recognise changes in relative prices (i.e. prices between
different goods), instead of being confused by
widespread changes in the general price level when
inflation is high. Consequently, they are able to make
well-informed consumption and investment decisions
and to allocate resources, i.e. their money, more
efficiently;
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reducing inflation risk premia in interest rates (i.e. the
“compensation” that investors demand for any
unexpected rise in inflation during the period of their
investment). This reduces real interest rates and boosts
incentives to invest;
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rendering unnecessary unproductive activities aimed
at hedging against the negative impact of inflation or
deflation, e.g. holding on to goods in the expectation
that their price may increase;
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reducing distortions of inflation or deflation, which can
exacerbate the distortionary impact on the economic
behaviour of tax and social security systems;
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preventing an arbitrary redistribution of wealth and
income as a result of unexpected periods of inflation or
deflation.
The role of the Eurosystem’s
monetary policy strategy
A monetary policy strategy is a coherent and structured
description of how monetary policy decisions are made in
order to achieve the objective of a central bank. The monetary
policy strategy for the euro area has two important tasks to
fulfil. First, by imposing a clear structure on the policy-making
process itself, it ensures that the ECB’s Governing Council has
at its disposal the necessary information and analyses
required to take monetary policy decisions. Second, it is a
vehicle for explaining such decisions to the public. By
contributing to the effectiveness of monetary policy, and by
signalling the Eurosystem’s commitment to price stability,
the strategy contributes to the credibility of the Eurosystem
in the financial markets.
By setting short-term interest rates, the monetary policy
decisions of the ECB’s Governing Council have an influence
on the economy and ultimately the price level.
Two-pillar approach
Basis for the interest rate decision
The ECB’s Governing Council has a specific approach to
determining the nature and extent of the risks to price
stability in the euro area over the medium term. This
approach to organising, evaluating and cross-checking the
information relevant for assessing the risks to price stability
is based on two complementary analytical perspectives,
referred to as the two “pillars”:
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the economic analysis,
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the monetary analysis.
The economic analysis is an assessment of the short to
medium-term influences on price developments, with a
focus on real activity (i.e. the production of goods and
services) and financial conditions in the economy.
It takes account of the fact that price developments over
those horizons are influenced largely by the interplay of
supply and demand in the goods, services and factor markets
(e.g. factors of production such as labour, capital and land).
The monetary analysis focuses on the longer term, and draws
on the long-run link between money and prices. It serves
mainly as a means of cross-checking, from a medium to
long-term perspective, the short to medium-term indications
for monetary policy stemming from the economic analysis.
The two-pillar approach is designed to ensure that no
relevant information is overlooked in the assessment of risks
to price stability and that sufficient attention is paid to
different perspectives and the cross-checking of information
in order to come to an overall judgement on the risks to price
stability. It represents a diversified analysis and ensures robust
decision-making.
Monetary policy instruments
Monetary policy operates by steering short-term interest
rates, thereby influencing economic developments in the
best possible way. The steering of short-term interest rates
is carried out through the operational implementation of
monetary policy. To this end, the Eurosystem has at its
disposal a set of monetary policy instruments, namely open
market operations, standing facilities and minimum reserves.
A: Open market operations
The most important monetary policy instrument is the open
market operation, which serves to:
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steer interest rates;
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manage the liquidity situation in the money market;
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signal the monetary policy stance.
Open market operations can be divided into the following
four categories:
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main refinancing operations, which are regular liquidityproviding
reverse transactions with a weekly frequency
and a maturity of one week;
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longer-term refinancing operations, which are liquidityproviding
reverse transactions with a monthly frequency
and a maturity of three months;
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fine-tuning operations, which are executed on an ad hoc
basis and are aimed at managing the liquidity situation
in the market and steering interest rates, in particular
to smooth the effects on interest rates of unexpected
fluctuations in market liquidity;
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structural operations, which are carried out through the
issuance of debt certificates, reverse transactions and
outright transactions.
B: Standing facilities
The Eurosystem also offers standing facilities, which aim
to provide and absorb overnight liquidity and set the
boundaries for overnight market interest rates:
The two standing facilities are:
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the marginal lending facility, which allows counterparties
(i.e. financial institutions such as banks) to obtain
overnight liquidity from the euro area national central
banks against eligible assets;
■■
the deposit facility, which can be used by counterparties
to make overnight deposits with the euro area national
central banks.
C: Minimum reserves
Finally, the Eurosystem requires credit institutions to hold
minimum reserves on accounts with the euro area national
central banks. The purpose of the minimum reserve system
is to stabilise money market interest rates and to create or
enlarge a structural liquidity shortage.
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