How does the European Central bank control inflation?
Author: Marco Murenu
Date of Publication: 22/02/2023
The objective of the European Central Bank is to keep prices at a stable level. But have you ever wondered how it does this? If so, keep reading this article.
Inflation: a short definition
Before analyzing how the ECB controls inflation, we should know what inflation is and how it is calculated. In particular, inflation is the general increase in price level and calculating inflation is quite easy:
1. You should calculate the Consumer Price Index (CPI), which is a weighted average of the prices of a basket of goods. Actually, each price has a different weight. That means that the prices of the most popular goods have a greater influence on the index. So, here is the formula:
2. Now, you can calculate the percentage increase (or decrease) of the current CPI compared to last year’s CPI. That’s what is called inflation rate:
If the inflation rate is a positive number, then the prices have increased (inflation). Whereas, if the inflation rate is a negative number, the prices have decreased (deflation).
What instrument does the ECB use to control inflation?
To begin with, let's take a look at the factors that cause inflation in order to understand the tools used by the ECB to control it. In fact, inflation occurs when currency is higher than the goods in sale. Companies decide to increase the price level of their goods to avoid exhausting stocks too quickly. This is because they are unable to cope with the high demand for goods and services caused by the excess of money.
As we have just seen, inflation is strongly linked to money supply. Generally speaking, when money supply decreases, the level of prices decreases too. Conversely, if money supply increases, then the price level increases as well. Therefore, to deal with inflation, the ECB uses policies that influence the money supply. Not surprisingly, these actions are known as monetary policies. So, the monetary policy instruments that the ECB uses are numerous. But the main ones are reserve requirements and the open market operations (OMOs).
Reserve requirements is the minimum amount that banks must hold in relation to deposits. In addition to that, they have to determine how much money the banking system is able to create with each euro of deposits collected. So, based on that, the European Central Bank may:
Increase reserve requirements; leading to a reduction in bank loans and thus a reduction in the money supply.
Reduce reserve requirements, encouraging banks to increase their loans and thus increasing the money supply.
Open Markets Operations
Private banks have an obligation to hold sufficient reserves to cover any liabilities. However, due to unpredictable changes in the flow of withdrawals and deposits, some banks may have insufficient reserves. In this case, they will borrow money from other banks that have excess reserves. In particular, these operations are executed in the money market. So, the ECB closely monitors the money market and may decide to inject or drain liquidity (namely to increase or reduce the money supply) into this market.
In fact, it can do so through open market operations. These are transactions through which the ECB purchases non-monetary financial assets from Private Banks. Those banks simultaneously agree to repurchase them later (no later than 2 weeks) at a price on which a predetermined interest rate is applied (refinancing rate). In this way, the Central Bank lends money to Private Banks at an interest rate, using the financial assets subject to sale as warranty.
Therefore, there are two cases:
If the Central Bank wants to increase the money supply, it will reduce the refinancing rate. To do so, it will have to buy financial assets from private banks. As a result, this would generate an increase in the money supply and a consequent reduction in the refinancing rate. In turn, a reduction in the refinancing rate would cause private banks to increase their loans. This is because they could return to the desired level of debt reserves at low cost. The increase in loans would lead to an increase in the money supply too.
If the Central Bank wants to reduce the money supply, it will increase the refinancing rate. To do this, it will be enough not to renew some loans. This would generate a reduction of the money supply and a consequent increase of the refinancing rate. In turn, if the refinancing rate increases, private banks would try to maintain the desired level of reserves without getting into debt with the Central Bank. So, in order to do so, they would have to reduce their loans, and this would generate a reduction in the money supply.
Macroeconomics, Zanichelli (2015), N. G. Mankiw, M.P. Taylor