Price stability: why is it important for you?

[Pages:10]Price stability: why is it important for you?

Teachers' booklet

? European Central Bank, 2007

Address Kaiserstrasse 29 60311 Frankfurt am Main Germany

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Author Dieter Gerdesmeier

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Photo credits Andreas Pangerl (p. 15) Corbis (pp. 23, 35) European Central Bank (pp. 1, 6, 9, 49, 52, 53, 71, 90) Image Source (p. 13) (pp. 10, 11, 14, 16, 17, 18, 19, 20, 21, 24, 29, 30, 33, 36, 44, 45, 57, 58, 59, 63, 72, 73, 75, 76, 79, 80, 81, 83, 85, 87, 88, 89)

All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged.

ISBN (print) 92-9181-786-4 ISBN (online) 92-9181-706-6

Price stability: why is it important for you?

Teachers' booklet

4 Contents

Foreword

6

Summary

9

Chapter 1 Introduction

13

Chapter 2 Money ? a short history

15

2.1 Functions of money

16

2.2 Forms of money

18

Chapter 3 The importance of price stability

23

3.1 What is price stability?

24

3.2 Measuring inflation

24

3.3 The benefits of price stability

29

Chapter 4 Factors determining price developments

35

4.1 What monetary policy can and cannot do ? an overview

36

4.2 Money and interest rates ? how can monetary policy influence

interest rates?

38

4.3 How do changes in interest rates affect the expenditure

decisions taken by consumers and firms?

39

4.4 Factors driving price developments over shorter-term horizons

44

4.5 Factors driving price developments over longer-term horizons

45

Chapter 5 The ECB's monetary policy

49

5.1 A short historical overview

50

5.2 The institutional framework

53

5.3 The ECB's monetary policy strategy

57

5.4 Overview of the Eurosystem's operational framework

71

Glossary Annex 1: The impact of inflation ? some quantitative illustrations Annex 2: Exercises Bibliography

5

75 77 79 87

Boxes

Box 3.1 Measuring inflation ? a simple example

25

Box 3.2 The relationship between expected inflation and

interest rates ? the so-called "Fisher effect"

27

Box 3.3 Hyperinflation

31

Box 3.4 Demand for cash

32

Box 4.1 Why can central banks influence (ex ante) real interest rates?

The role of "sticky" prices

38

Box 4.2 How do changes in aggregate demand affect economic activity

and price developments?

40

Box 4.3 The quantity theory of money

46

Box 5.1 The road to the single currency, the euro

50

Box 5.2 Convergence criteria

54

Box 5.3 Construction and features of the HICP

60

Box 5.4 A safety margin against deflation

61

Box 5.5 The medium-term orientation of the ECB's monetary policy

62

Box 5.6 Real economic and financial indicators

64

Box 5.7 Euro area macroeconomic projections

66

Box 5.8 Monetary aggregates

67

Box 5.9 The ECB`s reference value for monetary growth

68

6

Foreword

More than 300 million people in

thirteen European countries share the

euro as their currency. The Governing

Council of the European Central Bank

(ECB) is responsible for the single

Jean-Claude Trichet

monetary policy in these countries, which are known collectively as the

euro area. The Eurosystem, comprising the ECB and

the national central banks (NCBs) of the euro area has

a clear mandate assigned 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. This mandate reflects

a broad consensus in society that, by maintaining price

stability, monetary policy contributes significantly to

sustainable growth, economic welfare and helps create

jobs.

The Eurosystem has been granted independence in order

to carry out its 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

7

order to conduct its single monetary policy. In short, the Eurosystem has all the tools and skills needed to conduct a successful monetary policy. Like any important and independent institution in modern society, the Eurosystem needs to be close 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 ECB's monetary policy is geared towards achieving this mandate.

Jean-Claude Trichet President of the European Central Bank

8 Acknowledgements

This book has benefited greatly from numerous comments and drafting suggestions from my colleagues at the ECB, to whom I am most grateful. I would also like to express my gratitude to the members of the External Communications Committee of the European System of Central Banks (ESCB) and of the Board of Experts, colleagues from the ECB's Linguistic Services and Translation Divisions, H. Ahnert, J. Ahonen, W. Bier, D. Blenck, E. Bracke, D. Clarke, J. Cuvry, G. Deschamps, L. Dragomir, S. Ejerskov, G. Fagan, A. Ferrando, L. Ferrara, S. Keuning, H. J. Kl?ckers, D. Lindenlaub, A. Lojschova, K. Masuch, W. Modery, P. Moutot, H. Pill, C. Pronk, P. Rispal, B. Roffia, C. Rogers, P. Sandars, H. J. Schl?sser, R. K. Sch?ller, A. Spivack, G. Vitale, C. Zilioli.

Dieter Gerdesmeier Frankfurt am Main, January 2007

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