Money plays a key role in today`s economies. It is certainly no exaggeration to say that "money makes the world go round" and that modern economies could not function without money. The English word "money" is of Roman origin. In ancient Rome, however, the word "Monetor" or "Moneta" meant advisor, i. e. a person who warns or who makes people remember. According to some historians, the meaning of the word goes back to a key event in Roman history. A flock of geese in a sanctuary of the Goddess Juno on Capitoline Hill squawked an alarm to alert the Roman defenders during an invasion of the Gauls in 390 B. C. and thus saved them from defeat. In return, the Romans built a shrineto Moneta, the goddess who warns or who gives advice. In 289 B. C. the first Roman mint was built in or near this temple, initially producing bronze and later silver coins. Many of these coins were cast with the head of Juno Moneta on their face. Hence the words "money" and "mint" are derived from her name.

1.2. Functions of money

What is money? If we have to define money today, we first think of banknotes and coins. These assets are regarded as money since they are liquid. This means that they are accepted and are available to be used for payment purposes at any time. While it is uncontested that banknotes and coins fulfil this purpose, nowadays a number of other forms of assets exist which are very liquid and can be easily converted into cash or used to make a payment at very low cost. This applies, for instance, to overnight deposits and some other forms of deposits held with banks.2 Consequently, these instruments are included in those definitions of money often referred to as "broad money".

The various forms of money have changed substantially over time. Paper money and bank deposits did not always exist. It would therefore be useful to define money in more general terms. Money can be thought of as a very special good that fulfils some basic functions. In particular, it should serve as a medium of exchange, a store of value and a unit of account. Therefore, it is often stated that money is what money does.

In order to better illustrate these functions, consider how people had to conduct their transactions before the existence of money. Without money, people were forced to exchange goods or services directly for other goods or services through bartering. Although such a "barter economy" allows for some division of labour, there are practical limitations and any exchange of goods implies substantial so-called "transaction costs".

The most apparent problem with a barter economy is that people have to find a counterpart who wants exactly the same good or service that they are offering and who is offering what they want in return. In other words: a successful barter transaction requires a mutual coincidence of wants to exist. A baker who, for instance, wanted a haircut in exchange for some loaves of bread would have to find a hairdresser who is willing to accept those loaves of bread in exchange for a haircut. However, if the hairdresser needed a pair of shoes instead, he would have to wait until a shoe-shop owner wanted to get a haircut in exchange. Such a barter economy would therefore imply substantial costs related to searching for the appropriate counterpart and waiting and stockpiling.

1.2.1. Money as a medium of exchange

To avoid the inconveniences associated with a barter economy, one of the goods can be used as a medium of exchange. This crude form of money used for exchange is then called commodity money. Bartering one good against money and then money against another good might at first glance further complicate transactions. At second glance, however, it becomes clear that the use of one good as a medium of exchange facilitates the whole process to a considerable extent, as the mutual coincidence of wants is no longer required for an exchange of goods and services to take place. It is obvious that one precondition for this particular good to fulfil the function of money is that it is accepted throughout the economy as a medium of exchange, be it because of tradition,
informal convention or law.

At the same time, it is obvious that goods serving as a medium of exchange should have some specific technical properties. In particular, goods serving as commodity money should be easy to carry, durable, divisible and their quality should be easy to verify. In a more economic sense, of course, money should be a rare good, as only rare goods have a positive value.

1.2.2. Money as a store of value

If the good used as money maintains its value over time, it can be held for longer periods. This is particularly useful because it allows for the act of sale to be separated from the act of purchase. In this case, money fulfils the important function of a store of value.

It is for these reasons that commodities that also serve as a store of value are preferable to commodities that only serve as a medium of exchange. Goods such as fl owersor tomatoes, for instance, might in principle serve as a medium of exchange. However, they would not be useful as a store of value and would therefore probably not have been used as money. So if this function of money does not work properly (for instance if the good serving as money loses its value over time), people will make use of the value-storing function of other goods or assets or in extreme cases even go back to bartering.

1.2.3. Money as a unit of account

Of equal importance is the function of money as a unit of account. This can be illustrated by going back to our previous example. Even if the difficulty of the mutual coincidence of wants is overcome, people would still have to find the exact exchange ratio between bread and haircuts or between haircuts and shoes, for example. Such "exchange ratios" the number of loaves of bread worth one haircut, for instance are known as relative prices or terms of trade. In the market place, the relative price would have to be determined for each pair of goods and services and, of course, everybody Money should involved in the exchange of goods would need all the information about the terms serve as a medium of trade between all goods. It is easy to show that, for two goods, there is only one of exchange, a relative price, while for three goods there are just three relative prices (namely bread store of value and against haircuts, haircuts against shoes and bread against shoes). In the case of ten a unit of account. goods, however, there are already 45 relative prices, and with 100 goods the number of relative prices amounts to 4950.3 Therefore, the greater the number of goods being exchanged, the more difficult it becomes to gather information on all possible "exchange rates". Consequently, collecting and remembering information on the Money terms of trade creates high costs for the participants in a barter economy, increasing a short history disproportionately with the number of goods exchanged. These resources could be used more efficiently in other ways if one of the existing goods is used as a unit of account (a so-called "numeraire"). In this case, the value of all goods can be expressed in terms of this "numeraire" and the number of prices which consumers have to identify and remember can be reduced significantly.4 Therefore, if all prices were labelled in money terms, transactions would be much easier. More generally speaking, not only can the prices of goods be expressed in money terms, but so too can the price of any asset. All economic agents in the respective currency area would then calculate things such as costs, prices, wages, income, etc. in the same units of money. As in the above-mentioned functions of money, the less stable and reliable the value of money, the more difficult it is for money to fulfil this important function. A commonly accepted reliable unit of account thus forms a sound basis for price and cost calculations, thereby improving transparency and reliability.

1.3. Forms of money

Over time, the nature of goods serving as money has changed. It is widely agreed that what at times became the prime function of these goods was often not the same as their original purpose. It seems that goods were chosen as money because they could be stored conveniently and easily, had a high value but a comparably low weight, and were easily portable and durable. These widely desired goods were easy to exchange and, therefore, came to be accepted as money. So the evolution of money depends on a number of factors, such as the relative importance of trade and the state of development of the economy.

1.3.1. Commodity money

A variety of items have served as commodity money, including the wampum (beads made from shells) of the American Indians, cowries (brightly coloured shells) in India, whales' teeth in Fiji, tobacco in the early colonies in North America, large stone discs on the Pacific Island of Yap and cigarettes and liquor in post-World War II Germany.

1.3.2. Metallic Money

The introduction of metallic money was a way by which ancient societies tried to overcome the problems associated with using decaying commodities as money. It is not known exactly when and where metallic money was used for the first time. What is known, however, is that metallic money was in use in around 2000 B. C. in Asia, although in those times its weight does not seem to have been standardised nor its value certified by the rulers. Chunks or bars of gold and silver were used as commodity money since they were easy to transport, did not decay and were more or less easily divisible. Moreover, it was possible to melt them in order to produce jewellery.

1.3.3. Metallic coins

Europeans were among the first to develop standardised and certified metallic coins. The Greeks introduced silver coins around 700 B. C.; Aegina (595 B. C.), Athens (575 B. C.), and Corinth (570 B. C.) were the first Greek city-states to mint their own coins. The silver content of the Athenian drachma, famous for depicting the legendary owl, remained stable for nearly 400 years. Greek coins were therefore widely used (their use was further spread by Alexander the Great), and have been found by archaeologists in a geographical area ranging from Spain to modern India. The Romans, who had previously used cumbersome bronze bars called aes signatum as money, adopted the Greek innovation of using official coins and were the first to introduce a bi-metal scheme using both the silver denarius and the gold aureus.

Under the Emperor Nero in the first century A. D., the precious metal content of the coins started to diminish as the imperial mints increasingly substituted gold and silver for alloy in order to finance the empire's gigantic deficit. With the intrinsic value of the coins declining, the prices of goods and services began to rise. This was followed by a general rise in prices that may have contributed to the downfall of the Western Roman Empire. The more stable Eastern Roman solidus, introduced by Constantine the Great in the fourth century A. D., was maintained at its original weight and precious metal content until the middle of the 11th century, thus gaining a reputation that made it the most important coinage for international trade for over five centuries. Byzantine Greek coins were used as international money and were found by archaeologists as far away as Altai in Mongolia. In the mid-11th century, however, the Byzantine monetary economy collapsed and was replaced by a new system which lasted throughout the 12th century, until the Crusader conquest of Constantinople in 1204 eventually ended the history of Graeco-Roman coinage.

The Greeks and Romans had spread the custom of using coins and the technical knowledge of how to strike them over a vast geographical area. For most of the Middle Ages locally minted gold and silver coins were the dominant means of payment, although copper coins were increasingly being used. In 793 A. D. Charlemagne reformed and standardised the Frankish monetary system, introducing a monetary standard according to which one Frankish silver pound (408g) equalled 20 shillings or 240 pence this standard remained valid in the United Kingdom and Ireland until 1971.After the fall of Constantinople, the Italian merchant city-states of Genoa and Florence introduced gold coinage in 1252 with the genoin of Genoa and the farina (or florin) of Florence. In the 15th century their place was taken by the ducato of Venice.

1.3.4. Paper money

The Chinese began using paper money around 800 A. D. under Emperor Hien Tsung and continued to do so for several hundred years. This paper money had no commodity value and was money only by imperial decree, or so-called fiat money (i. e. money The Chinese began without intrinsic value). Paper money was most widespread in China around 1000 A. D., but it was abandoned around 1500 when Chinese society went into decline following the Mongol Conquest.

1.3.5. Obligations

It was, however, difficult to conduct long-distance trade as long as value could only be stored in the form of commodities and coins. The Italian city-states were therefore the first to introduce certificates of indebtedness ("obligations" or "bills of exchange") as a means of payment.

To reduce the risk of being robbed on their journeys, merchants took these obligations with them. Debtor and lender were mentioned in the certificates, a payment date was fixed, and the amount of gold or silver noted. Soon, merchant bankers began to trade these obligations. First evidence of such a contract dates back to 1156.

Obligations continued to be used mostly by Italian merchants, and the bi-metal scheme remained dominant until the Thirty Years' War. Due to the economic turmoil caused by the war, rulers such as the Swedish kings started to prefer paper money. This was subsequently introduced by the Bank of England in 1694 and the Banque générale in France in 1716. The advent of paper fiat money in Europe marked the beginning of a new phase in the evolution of money. The responsibility for establishing and regulating the system of fiat money in a country remained with the governments, but other public or private institutions such as central banks and the financial system played an increasingly crucial role in the success of the national currency.

1.3.6. Gold standard

Since the adoption of fiat money approximately two centuries ago the monetary system has undergone great change. Paper money was and still is legal tender only by an act of the competent authority. It was issued in fixed units of national currency and had a clearly defined nominal value. For a long time, the nation states held gold reserves in their central banks to ensure the credibility of their currency a system known as the Gold Standard. Currencies in the form of coins and fiduciary paper notes were convertible into gold at a fixed parity. The United Kingdom was effectively the first country to set up a gold standard in 1816, the exchange rate of pounds into gold having been determined in 1717 at 3.811 pounds sterling per ounce by Sir Isaac Newton himself.

With the start of World War I many countries began printing more and more money in order to finance the cost of the war. In Germany, for instance, the number of banknotes issued by the Reichsbank grew from 2,593 million in 1913 to a total of 92,844,720.7 billion banknotes in circulation on 18 November 1923. This ultimately led to hyperinflation.5 With more money circulating most countries suspended the convertibility of their currencies into gold as its increased quantity was no longer balanced by the national gold reserves.

1.3.7. Gold exchange standard

The British gold standard finally collapsed in 1931, but the system was revived at the currency.1944 international conference held in Bretton Woods, New Hampshire. Here, a revised gold standard was agreed upon: the exchange rates of the national currencies of the major economic powers were pegged to the dollar and the dollar was convertible into gold at a fixed price of USD 35 per ounce. The Bretton Woods monetary system is therefore sometimes called the gold exchange standard. Central banks stood ready to provide dollars in exchange for their national currency and vice versa.

The Bretton Woods monetary system collapsed in 1971 and since then the currencies of the major economies have remained pure fiat money. In addition, most countries have allowed the exchange rates of their currencies to float.

The evolution of money has not stopped. These days, various forms of intangible money have emerged, among them so-called "electronic money" ("e-money"), or electronic means of payment, which first appeared in the 1990s. This kind of money can be used to pay for goods and services on the internet or using other electronic media. Upon receiving authorisation from the buyer for the payment to take place, the vendor contacts the issuing bank and is transferred the funds. At present there are various card-based electronic money schemes in Europe, generally operated by financial institutions.

2. The importance of price stability

This chapter provides detailed information to help answer questions such as what price stability, inflation and deflation are, how inflation is measured, what the difference between nominal interest rates and the real return is, and what the benefits of price stability are, or in other words, why it is important for central banks to ensure price stability.

1.4. What is price stability?

1.4.1. Inflation and deflation

Inflation and deflation are important economic phenomenona that have negative consequences for the economy. Basically, inflation is defined as a general, or broadlybased, increase in the prices of goods and services over an extended period which consequently leads to a decline in the value of money and thus its purchasing power.

Deflation is often defined as the opposite of inflation, namely as a situation whereby the overall price level falls over an extended period.

When there is no inflation or deflation, we can say that there is price stability if, on average, prices neither increase nor decrease but stay stable over time. If, for instance, EUR 100 can buy the same basket of goods as it could, say, one and two years ago, then this can be called a situation of absolute price stability.

1.4.2. Movements in individual prices and in the general price level

It is important to make a distinction between movements in prices of any individual good or service and movements in the general price level. Frequent changes in individual prices are quite normal in market-based economies, even if there is price stability overall. The changes in supply and/or demand conditions of individual goods or services inevitably lead to changes in their price. For example, in recent years we have seen substantial declines in the prices of computers and mobile phones, mainly resulting from rapid technological progress. However, from the beginning of 1999 to mid-2006, oil and other energy prices increased, partly as a result of concerns regarding the future supply of energy and partly as a result of increased demand for energy, in particular from fast-growing economies. On the whole, inflation in most industrialised countries remained low and stable stability in the general price level can go hand-in-hand with substantial changes in individual prices as long as falling and rising prices off set each other so that the overall price level remains unchanged.

1.5. Measuring inflation

1.5.1. Measurement issues

How can inflation be measured? There are millions of individual prices in an economy. These prices are subject to continuous moves which basically reflect changes in the supply of and the demand for individual goods and services and thus give an indication of the "relative scarcity" of the respective goods and services. It is obvious that it is neither feasible nor desirable to take all of these prices into account, but neither is it appropriate to look at just a few of them, since they may not be representative of the general price level.

1.5.2. Consumer Price Index

Most countries have a simple common-sense approach to measuring inflation, using the so-called "Consumer Price Index" (CPI).6 For this purpose, the purchasing patterns of consumers are analysed to determine the goods and services which consumers typically buy and which can therefore be considered as somehow representative of the average consumer in an economy. As such they do not only include those items which consumers buy on a day-to-day basis (e. g. bread and fruit), but also purchases of durable goods (e. g. cars, PCs, washing machines, etc.) and frequent transactions (e. g. rents). Putting together this "shopping list" of items and weighting them according to their importance in consumer budgets leads to the creation of what is referred to as a "market basket".7 Each month, a host of "price surveyors" checks on the prices of these items in various outlets. Subsequently, the costs of this basket are then compared over time, determining a series for the price index. The annual rate of inflation can then be calculated by expressing the change in the costs of the market basket today as a percentage of the costs of the identical basket the previous year.

However, the developments of the price level as identified by such a basket only reflect the situation of an "average" or representative consumer. If a person's buying habits differ substantially from the average consumption pattern and thus from the market basket on which the index is based, that person may experience a change in the cost of living that is different to the one shown in the index. There will therefore always be some people who experience a higher "inflation rate" for their "individual basket" and some who face a lower "individual rate of inflation". In other words, the inflation measured by the index is only an approximate measure of the average situation in the economy; it is not identical to the overall price changes faced by each individual consumer.

1.5.3. Measurement problems

For various reasons, there are some difficulties associated with any attempt to express the overall change in prices as one number.

First, an existing basket usually becomes less and less representative over time as consumers increasingly substitute more expensive goods for cheaper ones. For example, higher petrol prices might lead some people to drive less and buy a higher quantity of other goods instead. Therefore, if the weights are not adjusted, the change in the index may slightly overestimate the "true" price increases. Second, changes in quality are sometimes difficult to incorporate into the price index. If the quality of a product improves over time and the price also rises, some of the change in price is due to the improved quality. Price increases which are due to quality changes cannot be considered as giving rise to inflation, as they do not reduce the purchasing power of money. Changes in quality are commonplace over long periods of time. For example, today's car differs considerably from those manufactured in the 1970s, which in turn were very different from those of the 1950s. Statistical offices spend a lot of time making adjustments for quality changes, but by their very nature such adjustments are not easy to estimate.

Apart from new varieties of existing goods (e. g. the introduction of new breakfast cereals), an important and difficult subject is the inclusion of new products. For example, after DVD players came on the market, there was an inevitable time lag until they could be captured in price statistics, since information on the market shares, the main distribution channels, the most popular makes, etc., was needed. But if it takes too long to incorporate new products into the price index, the price index fails to fully reflect the actual average price changes consumers are facing.

In the past, a number of economic studies have identified a small but positive bias in the measurement of national consumer price indices, suggesting that a measured inflation rate of, say, smaller than ½ percentage point might in fact be consistent with "true" price stability. For the euro area (i. e. all the EU countries that have adopted the euro as their currency), no precise estimates for such a measurement bias are available.

However, one can expect the size of such a possible bias to be rather small for two reasons. First, the Harmonised Index of Consumer Prices (HICP) this is a harmonised CPI for all euro area countries is a relatively new concept. Second, Eurostat, the European Commission agency responsible for this area of statistics at the EU level, has attempted to avoid a measurement bias in the HICP by setting appropriate statistical standards.

1.5.4. Nominal and real variables

As is explained above, in the case of inflation, a given amount of money can buy increasingly fewer goods. This is the same as saying that there is a fall in the value of money or a decrease in its purchasing power. This observation brings us on to another important economic issue: the difference between nominal and real variables. A nominal variable is one that is measured in current prices. Such variables usually move with the price level and therefore with inflation. In other words, the effects of inflation have not been accounted for. Real variables, however, such as real income or real wages, are variables where the effects of inflation have been deducted or "taken out".

Let us assume that a worker's earnings increase by 3 % in nominal (i. e. in money) terms per year, in other words his monthly earnings increase from, say, EUR 2000 to EUR 2060. If we further assume that the general price level were to increase by 1.5 % over the same period, which is equivalent to saying that the rate of inflation is 1.5 % per annum, then the increase in the real wage is ((103/101.5) 1) × 100 1.48 % (or approximately 3 % 1.5 % = 1.5 %). Therefore, the higher the rate of inflation for a given nominal wage increases, the fewer goods the worker can buy.

Another important distinction is between nominal and real interest rates (see also the Box below). By way of an example, let us suppose that you can buy a bond with a maturity of one year at face value which pays 4 % at the end of the year. If you were to pay EUR 100 at the beginning of the year, you would get EUR 104 at the end of the year. The bond therefore pays a nominal interest rate of 4 %. Note that the interest rate refers to the nominal interest rate, unless otherwise stated.

Now let us suppose that the inflation rate is again 1.5 % for that year. This is equivalent to saying that today the basket of goods will cost EUR 100, or next year it will cost EUR 101.5. If you buy a bond with a 4 % nominal interest rate for EUR 100, sell it after a year and get EUR 104, then buy a basket of goods for EUR 101.5, you will have EUR 2.5 left over. So, after factoring in inflation, your EUR 100 bond will earn you about EUR 2.5 in "real" income, which is equivalent to saying that the real interest rate is about 2.5 %. It is obvious that if inflation is positive then the real interest rate is lower than the nominal interest rate.

1.6. The benefits of price stability

1.6.1. Price stability supports higher living standards by helping to ...

The information above explains why inflation and deflation are generally undesirable phenomena. Indeed, there are substantial disadvantages and costs related to inflation and deflation. Price stability prevents these costs from arising and brings about important benefits for all citizens. There are several ways in which price stability helps to achieve high levels of economic welfare, e. g. in the form of high employment.

1.6.2. ... reduce uncertainty about general price developments and thereby improve the transparency of relative prices ...

First, price stability makes it easier for people to identify changes in the prices of goods expressed in terms of other goods (i. e. "relative prices"), since such changes are not concealed by fluctuations in the overall price level. For example, let us suppose that the price of a certain product increases by 3 %. If the general price level is stable, consumers know that the relative price of this product has increased and may therefore decide to buy less of it. If there is high and unstable inflation, however, it is more difficult to find out the relative price, which may have even declined. In such a situation it may be better for the consumer to buy relatively more of the product whose price has increased by "only" 3 %.

In the case of general deflation, consumers may not be aware of the fact that a fall in the price level of a single product merely reflects general price developments and not a fall in the relative price level of this good. As a result, they may mistakenly buy too much of this product.

Consequently, if prices are stable, firms and consumers do not run the risk of misinterpreting changes in the general price level as relative price changes and can make better informed consumption and investment decisions. Uncertainty about the rate of inflation may also lead firms to make wrong employment decisions. To illustrate this, let us suppose that in an environment of high inflation, a firm misinterprets the increase in the market price of its goods by, say, 5 %, as a relative price decrease as it is not aware that the inflation rate has recently fallen from, say, 6 % to 4 %. The firm might then decide to invest less and lay off workers in order to reduce its production capacities, as it would otherwise expect to make a loss given the perceived decrease in the relative price of its goods. However, this decision would ultimately turn out to be wrong, as the nominal wages of employees due to lower inflation may increase by less than that assumed by the firm. Economists would describe this as a people to identify "misallocation" of resources. In essence, it implies that resources (capital, labour, etc.) changes in the have been wasted, as some employees would have been made redundant because of instabilities in price developments.

A similar waste of resources would result if workers and unions were uncertain about future inflation and therefore demanded a rather high nominal wage increase in order to avoid high future inflation leading to significant declines in real wages. If firms had lower inflation expectations than workers/unions in such a situation, they would consider a given nominal wage increase as a rather high real wage increase and may therefore reduce their workforce or, at least, hire fewer workers than they would without the high "perceived" real wage increase.

Price stability reduces inflation uncertainty and therefore helps to prevent the misallocation of resources described above. By helping the market guide resources to where they can be used most productively, lasting price stability increases the efficiency of the economy and, therefore, the welfare of households.

1.6.3. ... reduce inflation risk premia in interest rates ...

Second, if creditors can be sure that prices will remain stable in the future, they will not demand an extra return (a so-called "inflation risk premium") to compensate them for the inflation risks associated with holding nominal assets over the longer term (see Box 3.2 for details). By reducing such risk premia, thereby bringing about lower nominal interest rates, price stability contributes to the efficiency with which the capital markets allocate resources and therefore increases the incentives to invest. This again fosters job creation and, more generally, economic welfare.

1.6.4. ... avoid unnecessary hedging activities ...

Third, the credible maintenance of price stability also makes it less likely that individuals and firms will divert resources from productive uses in order to protect themselves (i. e. to "hedge") against inflation or deflation, for example by indexing nominal contracts to price developments. As full indexation is not possible or is too costly, in a high-inflation environment there is an incentive to stockpile real goods since in such circumstances they retain their value better than money or certain financial assets. However, an excessive stockpiling of goods is clearly not an efficient investment decision and hinders economic and real income growth.

1.6.5. ... reduce distortionary effects of tax systems and social security systems ...

Fourth, tax and welfare systems can create incentives which distort economic behaviour. In many cases, these distortions are exacerbated by inflation or deflation, as fiscal systems do not normally allow for the indexation of tax rates and social security contributions to the inflation rate. For instance, salary increases that are meant to compensate workers for inflationary developments could result in employees being subject to a higher tax rate, a phenomenon that is known as "cold progression". Price stability reduces these distortionary effects associated with the impact of inflationary or deflationary developments on taxation and social systems.

1.6.6. ... increase the benefits of holding cash ...

Fifth, inflation can be interpreted as a hidden tax on holding cash. In other words, people who hold cash (or deposits which are not remunerated at market rates) experience a decline in their real money balances and thus in their real financial wealth when the price level rises, just as if part of their money had been taxed away. So, the higher the expected rate of inflation (and therefore the higher nominal interest rates), the lower the demand by households for cash holdings nominal interest rates imply a reduction in the demand for (non-remunerated) money). This happens even if inflation is not uncertain, i. e. if it is fully expected. Consequently, if people hold a lower amount of cash, they must make more frequent visits to the bank to withdraw money. These inconveniences and costs caused by reduced cash holdings are often metaphorically described as the "shoe-leather costs" of inflation, because walking to the bank causes one's shoes to wear out more quickly. More generally, reduced cash holdings can be said to generate higher transaction costs.

1.6.7. ... prevent the arbitrary distribution of wealth and income ...

Sixth, maintaining price stability prevents the considerable economic, social and political problems related to the arbitrary redistribution of wealth and income witnessed during times of inflation and deflation from arising. This holds true in particular if changes in the price level are difficult to anticipate, and for groups in society who have problems protecting their nominal claims against inflation. For instance, if there is an unexpected increase in inflation, everyone with nominal claims, for example in the form of longerterm wage contracts, bank deposits or government bonds, experiences losses in the real value of these claims. Wealth is then transferred in an arbitrary manner from lenders (or savers) to borrowers because the money in which a loan is ultimately repaid buys fewer goods than was expected when the loan was made.

Should there be unexpected deflation, people who hold nominal claims may stand to gain as the real value of their claims (e. g. wages, deposits) increases. However, in times of deflation, borrowers or debtors are often unable to pay back their debt and may even go bankrupt. This could damage society as a whole, and in particular those people who hold claims on, and those who work for, firms that have gone bankrupt.

Typically, the poorest groups of society often suffer the most from inflation or deflation, as they have only limited possibilities to hedge against it. Stable prices thus help to maintain social cohesion and stability. As demonstrated at certain points throughout the 20th century, high rates of inflation often create social and political instability as those groups who lose out because of inflation feel cheated if (unexpected) inflation "taxes" away a large part of their savings.

1.6.8. ... contribute to financial stability

Seventh, sudden revaluations of assets due to unexpected changes in inflation can undermine the soundness of a bank's balance sheet. For instance, let us assume that a bank provides long-term fixed interest loans which are financed by short-term time deposits. If there is an unexpected shift to high inflation, this will imply a fall in the real value of assets. Following this, the bank may face solvency problems that could cause adverse "chain effects". If monetary policy maintains price stability, inflationary or deflationary shocks to the real value of nominal assets are avoided and financial stability is therefore also enhanced.

1.6.9. By maintaining price stability, central banks contribute to broader economic goals

All of these arguments suggest that a central bank that maintains price stability contributes substantially to the achievement of broader economic goals, such as higher standards of living, high and more stable levels of economic activity and employment. This conclusion is supported by economic evidence which, for a wide variety of countries, methodologies and periods, demonstrates that in the long run, economies with lower inflation appear on average to grow more rapidly in real terms.

3. Factors determining price developments

This chapter provides detailed information to help answer questions such as what determines the general price level or what the factors are that drive inflation, how the central bank, or more precisely monetary policy, is able to ensure price stability, what the role of fiscal policy is,

and whether monetary policy should focus directly on enhancing real growth or reducing unemployment, or in other words, what monetary policy can and cannot achieve.

In the previous sections we have looked at issues associated with measuring inflation and the advantages of price stability. However, we have not touched directly upon the causes that determine general price developments. In the following sections we will focus on the causes of inflation the latter being defined as a general, or broadly-based, increase in the prices of goods and services which is equivalent to a loss in the purchasing power of money. Before going into details, we will provide a short overview of the role and effects of monetary policy. This will help to put other factors into perspective.

1.7. What monetary policy can and cannot do an overview

How can monetary policy influence the price level? This question touches upon what economists generally describe as the so-called "transmission process", i. e. the process through which actions of the central bank are transmitted through the economy and, ultimately, to prices. While this process is in essence extremely complex, one that changes over time and is different in various economies, so much so that, even today, not all the details behind it are fully known, its basic features are well understood. The way in which monetary policy exerts its influence on the economy can be explained as follows: the central bank is the sole issuer of banknotes and bank reserves, i. e. it is the monopolistic supplier of the so-called "monetary base". By virtue of this monopoly, the central bank is able to influence money market conditions and steer short-term interest rates.

1.7.1. In the short run, the central bank can influence real economic developments

In the short run, a change in money market (i. e. short-term) interest rates induced by the central bank sets a number of mechanisms in motion, mainly because this change has an impact on the spending and saving decisions taken by households and firms. For example, higher interest rates will, all things being equal, make it less attractive for households and firms to take out loans in order to finance their consumption or investment. They also make it more attractive for households to save their current income rather than spend it. Finally, changes in official interest rates may also affect the supply of credit. These developments, in turn, and with some delay, influence developments in real economic variables such as output.

1.7.2. In the long run, changes in the money supply will affect the general price level ...

The dynamic processes outlined above involve a number of different mechanisms and actions taken by various economic agents at different stages of the process. Furthermore, the size and strength of the various effects can vary according to the state of the economy. As a result, monetary policy usually takes a considerable amount of time to affect price developments. However, in the economics profession, it is widely accepted that, in the long run, i. e. after all adjustments in the economy have worked through, a change in the quantity of money supplied by the central bank (all things being equal) will only be reflected in a change in the general level of prices and will not cause permanent changes in real variables such as real output or unemployment. A change in the quantity of money in circulation brought about by the central bank is ultimately equivalent to a change in the unit of account (and thereby in the general price level), which leaves all other variables stable, in much the same way as changing the standard unit used to measure distance (e. g. switching from kilometres to miles) would not alter the actual distance between two locations.

1.7.3. ... but not the level of real income or employment

This general principle, referred to as the "long-run neutrality" of money, underlies all standard macroeconomic thinking and theoretical frameworks. As mentioned above, a monetary policy which credibly maintains price stability has a significant positive impact on welfare and real activity. Beyond this positive impact of price stability, real income or the level of employment in the economy are, in the long run, essentially determined by real (supply-side) factors, and cannot be enhanced by expansionary monetary policy.9 These main determinants of long-run employment and real income are technology, population growth and all aspects of the institutional framework of the economy (notably property rights, tax policy, welfare policies and other regulations determining the flexibility of markets and incentives to supply labour and capital and to invest in human resources).

1.7.4. Inflation is ultimately a monetary phenomenon

Inflation is ultimately a monetary phenomenon. As confirmed by a number of empirical studies, prolonged periods of high inflation are typically associated with high monetary growth (see Chart below). While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be off set by some degree of adjustment of monetary policy. In this sense, the longer-term trends of prices or inflation can be controlled by central banks.

In this short overview a number of points have been addressed which may require further explanation. As inflation is ultimately a monetary phenomenon, it seems necessary to explain in greater detail how monetary policy affects the economy and, ultimately, price developments. This is best addressed in three steps.

First, in Section 4.2, we discuss why and how monetary policy can influence interest rates. Second, in Section 4.3 we consider how changes in interest rates can affect expenditure decisions taken by consumers and firms. Finally, we analyse how these changes in aggregate demand affect price developments. In this context we also discuss other, i. e. non-monetary or real, factors which can affect price developments over the shorter term. It may be useful to understand the overall or aggregate supply and demand for goods in an economy (see Box 4.2) and to distinguish between short and long-run effects (Sections 4.4 and 4.5).

1.8. Money and interest rates how can monetary policy influence interest rates?

A central bank can determine the short-term nominal interest rates which banks have to pay when they want to get credit from the central bank. And banks need to go to the central bank for credit as they need banknotes for their clients and need to fulfil minimum reserve requirements in the form of deposits with the central bank.

As central banks are the only institutions which can issue banknotes (and bank reserves), i. e. they are the monopolistic suppliers of base money, they can determine the policy rates, e. g. the short-term nominal interest rates on loans given to the banks. The expectations regarding the future development of policy rates in turn influence a wide range of longer-term bank and market interest rates.

1.9. How do changes in interest rates affect the expenditure decisions taken by consumers and firms?

From the perspective of an individual household, a higher real interest rate makes it more attractive to save, since the return on saving in terms of future consumption is higher. Therefore, higher real interest rates typically lead to a fall in current consumption and an increase in savings. From a firm's standpoint, a higher real interest rate will, provided all other variables remain the same, deter investment, because fewer of the available investment projects will offer a return sufficient to cover the higher cost of capital.

To sum up, an interest rate rise will make current consumption less desirable for households and discourage current investment by firms. The effects on individual households and firms show that an increase in real interest rates brought about by monetary policy will lead to a reduction in current expenditure in the economy as a whole (if the other variables remain constant). Economists say that such a policy change causes a drop in aggregate demand and is thus often referred to as a "tightening" of monetary policy.

It is important to understand that there are time lags in this process. It might easily take months for firms to put a new investment plan in place; investments involving the construction of new plants or the ordering of special equipment can even take years. Housing investment also takes some time to respond to changes in interest rates. Also, many consumers will not immediately change their consumption plans in response to changes in interest rates.

Indeed, it is generally agreed that the overall transmission process of monetary policy takes time. Monetary policy cannot, therefore, control the overall demand for goods developmentsand services in the short run. Expressed in another way, there is a significant time lag between a change in monetary policy and its effect on the economy.

1.10. Factors driving price developments over shorter-term horizons

In the following, we will investigate some factors driving short-term price developments. As explained in more detail in Box 4.2, inflation (i. e. a sustained increase in the price level) could be caused in either one or two ways. Prices in general will rise if, on average, either aggregate demand increases or supply decreases. To put it differently, inflationary pressures can result if there are changes (economists often speak of "shocks" if there are unexpected changes in economic developments) which lead consumers to increase their expenditure or firms to reduce their production. The first instance, where demand increases, resulting in inflation, is often described as "demand-pull inflation" in the economic literature. The second instance, where costs increase and supply therefore decreases, thus also resulting in inflation, is often labelled as "cost-push inflation". The opposite happens, i. e. deflationary pressures emerge, if aggregate demand falls or aggregate supply increases. In general, monetary policy often has to respond to such
developments in order to ensure price stability. In cases of inflationary pressure, the central bank would normally increase (real) interest rates to prevent that pressure from translating into more persistent deviations from price stability.

Price increases that arise because of an increase in aggregate demand may result from any individual factor that increases aggregate demand, but the most significant of these factors, besides monetary policy (increases in the money supply), are increases in government purchases, depreciation of the exchange rate and increased demand pressures for domestic goods from the rest of the world (exports). Changes in aggregate demand can also be caused by increased confidence. It is likely, for example, that firms will invest more if higher profits can be expected in the future. Changes in aggregate demand will normally increase the price level and, temporarily, aggregate production (see Box 4.2).

What precisely are the factors leading to a reduction in aggregate supply and thus to higher prices in the short run? The main sources of falling aggregate supply are decreases in productivity, increases in production costs (for instance, increases in real wages and in the prices of raw materials, notably oil), and higher corporate taxes imposed by governments. If all other factors remain the same, the higher the cost of production, the smaller the amount produced at the same price.

For a given price level, if wages or the costs of raw materials, such as oil, rise, firms are forced to reduce the number of people they employ and to cut production. As this is the result of supply-side effects, the resulting inflation is often referred to as "cost-push inflation".

Various circumstances could cause the price of inputs to rise, for instance, if the supply of the worldwide raw materials such as oil falls short of expectations, or if the worldwide demand for raw materials rises. Increases in real wages (which are not matched by increased productivity) will also lead to a decline in aggregate supply and lower employment. Such wage increases may result from a decline in the labour supply, which in turn may have been caused by a government regulation which has the effect of reducing the incentives to work (e. g. higher taxes on labour income). An increase in the power of trade unions can also result in higher real wages.

If the factors described above work in the other direction, we will see an increase in aggregate supply. For example, an increase in productivity (e. g. based on new technologies) would, all things being equal, lead to lower prices and higher employment in the short run as it becomes more profitable to hire labour at given wages. However, if real wages were to increase in line with productivity, employment would remain unchanged.

1.10.1. The role of expected inflation

When firms and employees negotiate wages and when firms set their prices, they often consider what the level of inflation may be in the period ahead, for example, over the following year. Expected inflation matters for current wage settlements as future price rises will reduce the quantity of goods and services that a given nominal wage can buy. So, if inflation is expected to be high, employees might demand a higher nominal wage increase during wage negotiations. Firms' costs increase if wage settlements are based on these expectations and these costs could be passed on to customers in the form of higher prices. A similar case can be made for price-setting on the part of firms. As many individual prices remain fixed for a particular period (for one month or one year, for example; see Box 4.1), firms which had planned to publish a new price list may increase their individual prices with immediate effect if they anticipate increases in the general price level or in wages in the future. So if people expect inflation in the future, their behaviour can already cause a rise in inflation today. This is another reason why it is very important for monetary policy to be credible in its objective of maintaining price stability in order to stabilise longer-term inflation expectations at low levels, in line with price stability.

Taken together, a variety of factors and shocks can influence the price level in the short run. Among them are developments in aggregate demand and its various components, including developments in fiscal policy. Further changes could relate to changes in input prices, in costs and productivity, in developments in the exchange rate, and in the global economy. All these factors could affect real activity and prices over shorter-term horizons. But what about longer-term horizons?

This brings us to another important distinction in economics. Economists generally draw a distinction between the short run and the long run (see also Box 4.2).

1.11. Factors driving price developments over longer-term horizons

What is the relative importance of these factors on inflation over longer-term horizons? Or in other words: are they all of equal relevance as regards inflationary trends? The answer is clearly "no". We shall see that monetary policy plays a crucial role here.

As already mentioned in previous paragraphs, there is a time lag of about one to three years between changes in monetary policy and the impact on prices. This implies that monetary policy cannot prevent unexpected real economic developments or shocks from having some short-run impact on inflation. However, there is widespread agreement among economists that monetary policy can control price developments over the longer term and therefore also the "trend" of inflation, i. e. the change in the price level when the economy has fully incorporated short-term disturbances.

In the long run, prices are flexible and can respond fully to changes in supply and demand. However, in the short run many individual prices are sticky and will remain at their current levels for some time (see Box 4.1).

How does this distinction influence our results? Without going into too much detail, it can be argued that output does not depend on the price level in the long run. It is determined by the given stock of capital; by the labour force available and the quality of that labour force; by structural policies which influence incentives to work and to invest; and by any technological developments in the field of production. In other words, the long-term level of output depends on a number of real or supply-side factors. These factors determine the exact position of the aggregate supply curve.

The other curve that determines the state of equilibrium of the economy is the aggregate demand curve. As we have seen, a number of factors can lead to increases in aggregate demand. Among them are increases in government expenditures, in external demand for exports, and in improved expectations of future productivity developments which might have an impact on current consumption and investment. It is obvious, however, that although many of these factors can increase even for a protracted period, a sustained increase in the general price level can, in the long run, only be driven by a sustained and ongoing expansionary monetary policy. This point is often made in terms of the famous statement according to which "inflation is always and everywhere a monetary phenomenon". Indeed, a number of empirical studies have provided evidence in favour of this hypothesis. The ultimate reason for an inflationary process in the longer run is, therefore, a sustained increase in money supply which is equivalent to a sustained expansionary monetary policy. In a longer-term perspective, monetary policy actions thus determine whether inflation is allowed to rise or is kept low. In other words, a central bank that controls the money supply and the short-term interest rate has ultimate control over the rate of inflation over longer-term horizons. If the central bank keeps short-term interest rates too low and increases the money supply by too much, the price level will ultimately also increase. This basic result is illustrated by the fundamental economic concept which addresses in more detail the relationship between money and prices, namely the quantity theory of money (see Box 4.3 below).

4. The ECB's monetary policy

This chapter provides detailed information to help answer questions such as how EMU came about, which body is responsible for the single monetary policy in the euro area, what the primary objective of the Eurosystem is, and how it tries to achieve its mandate.

1.12. A short historical overview

1.12.1. History the three stages of Economic and Monetary Union

The idea that Europe should have a single, unified and stable monetary system has its roots far back in history (see Box 5.1). After one unsuccessful attempt in the early 1970s, a decisive impetus to the integration process came about in June 1988, when the European Council reconfirmed the objective to gradually achieve economic and monetary union. A committee chaired by Jacques Delors, the then President of the European Commission, was set up to study and propose concrete stages leading to this union. The committee's report (the so-called "Delors Report"), presented in April 1989, proposed the introduction of an Economic and Monetary Union (EMU) in three discrete but evolutionary steps.

1.12.2. Stage One of EMU

Following the Delors Report, the European Council, in June 1989, decided that the first stage of EMU should be launched on 1 July 1990. At the same time, the Committee of Governors of the central banks of the Member States of the European Economic Community, which had played an increasingly important role in monetary co-operation since it was established in May 1964, was given additional responsibilities.

In order for Stages Two and Three to take place, the Treaty establishing the European Community (the so-called "Treaty of Rome") had to be revised so that the required institutional structure could be established. For this purpose, an Intergovernmental Conference on EMU was held in 1991 in parallel with the Intergovernmental Conference on political union. The Committee of Governors submitted the draft Statute of the ESCB and of the ECB to the Intergovernmental Conference. The negotiations resulted in the Treaty on European Union, which was agreed in December 1991 and signed in Maastricht on 7 February 1992. However, owing to delays in the ratification process, it did not come into force until 1 November 1993.

1.12.3. Stage Two of EMU: the establishment of the EMI and the ECB

The establishment of the European Monetary Institute (EMI) on 1 January 1994 marked the start of the second stage of EMU. Henceforth, the Committee of Governors ceased to exist. The EMI's transitory existence also mirrored the state of monetary integration within the Community: the EMI had no responsibility for the conduct of monetary policy in the European Union (this remained the responsibility of the national authorities) nor had it any competence for carrying out foreign exchange intervention.

The two main tasks of the EMI were first to strengthen central bank cooperation and monetary policy coordination; and second to make the preparations required for the establishment of the ESCB, for the conduct of the single monetary policy and for the creation of a single currency in the third stage.

In December 1995, the European Council meeting in Madrid agreed on the name of the European currency unit to be introduced at the start of Stage Three, the "euro", and confirmed that Stage Three of EMU would start on 1 January 1999. A chronological sequence of events was pre-announced for the changeover to the euro. This scenario was based mainly on detailed proposals drawn up by the EMI. At the same time, the EMI was given the task of carrying out preparatory work on the future monetary and exchange rate relationships between the euro area and other EU countries. In December 1996 the EMI presented a report to the European Council which formed the basis of a Resolution of the European Council on the principles and fundamental elements of the new exchange rate mechanism (ERM II), which was adopted in June 1997.

In December 1996 the EMI also presented to the European Council, and subsequently to the public, the selected design series for the euro banknotes to be put into circulation on 1 January 2002. In order to both complement and clarify the Treaty's provisions on EMU, in June 1997 the European Council adopted the Stability and Growth Pact to ensure budgetary discipline in respect of EMU. The Pact was supplemented and the respective commitments enhanced by a Declaration of the Council in May 1998.

On 2 May 1998 the Council of the European Union in its composition of Heads of State or Government decided that 11 Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland) had fulfilled the conditions necessary for the adoption of the single currency on 1 January 1999.

At the same time, the finance ministers of the Member States adopting the single currency agreed, together with the governors of the NCBs, the European Commission and the EMI, that the ERM central rates of the currencies of the participating Member States would be used to determine the irrevocable conversion rates for the euro.

On 25 May 1998 the governments of the 11 participating Member States officially appointed the President, the Vice-President and the four other members of the Executive Board of the ECB. Their appointment came into effect on 1 June 1998 and marked the establishment of the ECB.

With this, the EMI had completed its tasks. In accordance with Article 123 of the Treaty establishing the European Community, the EMI went into liquidation. All the preparatory work entrusted to the EMI was concluded in good time and the ECB spent the rest of 1998 carrying out final tests of systems and procedures.

1.12.4. Stage Three of EMU, the irrevocable fixing of exchange rates

On 1 January 1999 the third and final stage of EMU began with the irrevocable fixing of the exchange rates of the currencies of the 11 Member States which had initially participated in monetary union and with the conduct of a single monetary policy under the responsibility of the ECB.

The number of participating Member States increased to 13 on 1 January 2007, when Slovenia entered the third stage of EMU. This followed on from a decision taken on 11 July 2006 by the EU Council meeting in the composition of the Heads of State or Government in which it was acknowledged that Slovenia fulfilled the convergence criteria.

1.13. The institutional framework

1.13.1. The European System of Central Banks

The ECB was established on 1 June 1998 and is one of the world's youngest central banks. However, it has inherited the credibility and expertise of all euro area NCBs, which together with the ECB implement the monetary policy for the euro area.The legal basis for the ECB and the European System of Central Banks (ESCB), is the Treaty establishing the European Community. According to this Treaty, the ESCB is composed of the ECB and the NCBs of all EU Member States (27 since 1 January 2007). The Statute of the ESCB and of the ECB is attached to the Treaty as a protocol.

1.13.2. Mandate of the ESCB

The Treaty states that "the primary objective of the ESCB shall be to maintain price stability" and that "without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2". Article 2 of the Treaty mentions as objectives of the Community, inter alia, "a high level of employment (...), sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance". The Treaty thus establishes a clear hierarchy of objectives and assigns overriding importance to price stability. By focusing the monetary policy of the ECB on this primary objective, the Treaty makes it clear that ensuring price stability is the most important contribution that monetary policy can make to achieving a favourable economic environment and a high level of employment.

1.13.3. The Eurosystem

The 13 NCBs in the euro area, together with the ECB, form the Eurosystem. This term was chosen by the Governing Council to describe the arrangement by which the ESCB carries out its tasks within the euro area. As long as there are EU Member States which have not yet adopted the euro, this distinction between the Eurosystem and the ESCB will need to be made. The NCBs of the EU Member States which have not yet adopted the euro consisting of the "old" EU Member States of Denmark, Sweden and the United Kingdom plus nine of the 10 countries that joined the European Union on 1 May 2004 (Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland and Slovakia) and, since 1 January 2007, the new EU Member States of Bulgaria and Romania are not involved in decision-making regarding the single monetary policy for the euro area and continue to have their own national currencies and conduct their own monetary policies. An EU country can adopt the euro at a later stage but only once it has fulfilled the convergence criteria (see Box below for a more detailed description). This was the case of Slovenia, which joined the euro area on 1 January 2007.

1.13.4. ... and its basic tasks ...

The basic tasks of the Eurosystem are to:· define and implement the monetary policy for the euro area;· conduct foreign exchange operations and to hold and manage the official foreign reserves of the euro area countries;· promote the smooth operation of payment systems.

Further tasks are to:· authorise the issue of banknotes in the euro area; · give opinions and advice on draft Community acts and draft national legislation;· collect the necessary statistical information either from national authorities or directly from economic agents, e. g. financial institutions;· contribute to the smooth conduct of policies pursued by the authorities in charge of prudential supervision of credit institutions and the stability of the financial system.

1.13.5. The Governing Council

The highest decision-making body of the ECB is the Governing Council. It consists of the six members of the Executive Board and the governors of the NCBs of the euro area (13 in 2007). Both the Governing Council and the Executive Board are chaired by the President of the ECB (see also Chart below).

The key task of the Governing Council is to formulate the monetary policy for the euro area. Specifically, it has the power to determine the interest rates at which credit institutions may obtain liquidity (money) from the Eurosystem. Thus the Governing Council indirectly influences interest rates throughout the euro area economy, including the rates that credit institutions charge their customers for loans and those that savers earn on their deposits. The Governing Council fulfils its responsibilities by adopting guidelines and taking decisions.

1.13.6. The Executive Board

The Executive Board of the ECB consists of the President, the Vice-President and four other members. All are appointed by common accord of the Heads of State or Government of the countries which form the euro area. The Executive Board is responsible for implementing the monetary policy as formulated by the Governing Council and gives the necessary instructions to the NCBs for this purpose. It also prepares the meetings of the Governing Council and manages the day-to-day business of the ECB.

1.13.7. The General Council

The third decision-making body of the ECB is the General Council. It comprises the President and the Vice-President of the ECB and the governors of all 27 NCBs of the EU Member States. The General Council has no responsibility for monetary policy decisions in the euro area. It contributes to the co-ordination of monetary policies of the Member States that have not yet adopted the euro and to the preparations for the possible enlargement of the euro area.

1.13.8. Independence

There are good reasons to entrust the task of maintaining price stability to an independent central bank not subject to potential political pressures. In line with the provisions of the Treaty stablishing the European Community, the Eurosystem enjoys full independence in performing its tasks: neither the ECB, nor the NCBs in the Eurosystem, nor any member of their decision-making bodies may seek or take instructions from any other body. The Community institutions and bodies and the governments of the Member States are bound to respect this principle and must not seek to influence the members of the decision-making bodies of the ECB or of the NCBs. Furthermore, the Eurosystem may not grant any loans to Community bodies or national government entities. This shields it further from political interference. The Eurosystem has all the instruments and competencies it needs to conduct an efficient monetary policy. The members of the ECB's decision-making bodies have long terms of office and can be dismissed only for serious misconduct or the inability to perform their duties. The ECB has its own budget, independent of that of the European Community. This keeps the administration of the ECB separate from the financial interests of the Community.

1.13.9. Capital of the ECB

The capital of the ECB does not come from the European Community but has been subscribed and paid up by the NCBs. The share of each Member State in the European Union's gross domestic product and population determines the amount of each NCB's subscription.

1.14. The ECB's monetary policy strategy General principles

1.14.1. The mandate and task of monetary policy

As already mentioned, the Treaty establishing the European Community assigns to the Eurosystem the primary objective of maintaining price stability in the euro area. In particular it states that "the primary objective of the ESCB shall be to maintain price stability".

The challenge faced by the ECB can be stated as follows: the Governing Council of the ECB has to influence conditions in the money market, and thereby the level of short-term interest rates, to ensure that price stability is maintained over the medium term. Below some key principles of a successful monetary policy are explained.

1.14.2. Monetary policy should firmly anchor inflation expectations ...

First, monetary policy is considerably more effective if it firmly anchors inflation expectations (see also Section 3.3). In this regard, central banks should specify their goals, elaborate them and stick to a consistent and systematic method for conducting monetary policy, as well as communicate clearly and openly. These are key elements for acquiring a high level of credibility, a necessary precondition for influencing the expectations of economic actors.

1.14.3. ... must be forward-looking ...

Second, owing to the lags in the transmission process (see Section 4.3), changes in monetary policy today will only affect the price level after a number of quarters or years. This means that central banks need to ascertain what policy stance is needed in order to maintain price stability in the future, once the transmission lags have unwound. In this sense, monetary policy must be forward-looking.

1.14.4. ... focus on the medium term ...

As the transmission lags make it impossible for monetary policy to off set unanticipated shocks to the price level (for example, those caused by changes in international commodity prices or indirect taxes) in the short run, some short-term volatility in inflation rates is inevitable (see also Section 4.4). In addition, owing to the complexity of the monetary policy transmission process, there is always a high degree of uncertainty surrounding the effects of economic shocks and monetary policy. For these reasons, monetary policy should have a medium-term orientation in order to avoid excessive activism and the introduction of unnecessary volatility into the real economy.

1.14.5. ... and be broadly based

Finally, just like any other central bank, the ECB faces considerable uncertainty about the reliability of economic indicators, the structure of the euro area economy and the monetary policy transmission mechanism, among other things. A successful monetary policy therefore has to be broadly based, taking into account all relevant information in order to understand the factors driving economic developments, and cannot rely on a small set of indicators or a single model of the economy.

1.14.6. The role of the strategy: a comprehensive framework for monetary policy decisions

The Governing Council of the ECB has adopted and announced a monetary policy strategy to ensure a consistent and systematic approach to monetary policy decisions. This monetary policy strategy embodies the above-mentioned general principles in order to meet the challenges facing the central bank. It aims to provide a comprehensive framework within which decisions on the appropriate level of short-term interest rates can be taken and communicated to the public.

1.14.7. The main elements of the ECB's monetary policy strategy

The first element of the ECB's monetary policy strategy is a quantitative definition of price stability. In addition, the strategy establishes a framework to ensure that the Governing Council assesses all the relevant information and analyses needed to take monetary policy decisions such that price stability over the medium term is maintained. The remaining sections of this chapter describe these elements in detail.

1.15. The quantitative definition of price stability

1.15.1. Primary objective

The primary objective of the Eurosystem is to maintain price stability in the euro area, thus protecting the purchasing power of the euro. As discussed earlier, ensuring stable prices is the most important contribution that monetary policy can make in order to achieve a favourable economic environment and a high level of employment. Both inflation and deflation can be very costly to society economically and socially speaking (see in particular Section 3.3). Without prejudice to its primary objective of price stability, the Eurosystem also supports the general economic policies in the European Community. Furthermore, the Eurosystem acts in accordance with the principles of an open market economy, as stipulated by the Treaty establishing the European Community.

1.15.2. The ECB has defined price stability in quantitative terms

While the Treaty clearly establishes the maintenance of price stability as the primary objective of the ECB, it does not give a precise definition. In order to specify this objective more precisely, the Governing Council of the ECB announced the following quantitative definition in 1998: "Price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 %. Price stability is to be maintained over the medium term". In 2003, the Governing Council further clarified that, within the definition, it aims to maintain inflation rates below but "close to 2 % over the medium term".

1.15.3. The definition both anchors inflation expectations and adds to the ECB's transparency and accountability

The Governing Council decided to publicly announce a quantitative definition of price stability for a number of reasons. First, by clarifying how the Governing Council interprets the goal it has been assigned by the Treaty, the definition helps to make the framework easier to understand (i. e. it makes monetary policy more transparent). Second, the definition of price stability provides a clear and measurable yardstick against which the public can hold the ECB accountable. In case of deviations of price developments from the definition of price stability, the ECB would be required to provide an explanation for such deviations and to explain how it intends to re-establish price stability within an acceptable period of time. Finally, the definition gives guidance to the public, allowing it to form its own expectations regarding future price developments (see also Box 3.2).

1.15.4. Features of the definition: focus on the euro area as a whole

The definition of price stability has a number of noteworthy features. First, the ECB has a euro area-wide mandate. Accordingly, decisions regarding the single monetary 60policy aim to achieve price stability in the euro area as a whole. This focus on the euro area as a whole is the natural consequence of the fact that, within a monetary union, monetary policy can only steer the average money market interest rate level in the area, i. e. it cannot set different interest rates for different regions of the euro area.

1.15.5. The HICP

The definition also identifies a specific price index namely the HICP for the euro area as that to be used for assessing whether price stability has been achieved. The use of a broad price index ensures the transparency of the ECB's commitment to full and effective protection against losses in the purchasing power of money (see also Section 3.2).

The HICP, which is released by EUROSTAT, the Statistical Office of the European Union, is the key measure for price developments in the euro area. This index has been harmonised across the various countries of the euro area with the aim of measuring price developments on a comparable basis. The HICP is the index that most closely allows one to approximate the changes over time in the price of a representative basket of consumer expenditures in the euro area (see Box 5.3).

1.15.6. Reasons for aiming at inflation rates of below but close to 2 %

By referring to "an increase in the HICP of below 2 %", the definition makes it clear that both inflation above 2 % and deflation (i. e. declines in the price level) are inconsistent with price stability. In this respect, the explicit indication by the ECB to aim to maintain the inflation rate at a level below but close to 2 % signals its commitment to provide an adequate margin to avoid the risks of deflation (see Section 3.1 and also the Box below).

By aiming at "an increase of the HICP of below but close to 2 %", a possible measurement bias in the HICP and the potential implications of inflation differentials in the euro area are also taken into account.

1.15.7. The medium-term orientation

Finally, a key aspect of the ECB's monetary policy is that it aims to pursue price stability "over the medium term". As outlined above, this reflects the consensus that monetary policy cannot, and therefore should not, aim to attempt to fine-tune developments in prices or inflation over short horizons of a few weeks or months (see also Section 4.4). Changes in monetary policy only affect prices with a time lag, and the magnitude of the eventual impact is uncertain. This implies that monetary policy cannot off set all unanticipated disturbances to the price level. Some short-term volatility in inflation is therefore inevitable.

1.16. The two pillars of the ECB's monetary

1.16.1. The two-pillar framework is a tool for organising information ...

The ECB's approach to organising, evaluating and cross-checking the information relevant for assessing the risks to price stability is based on two analytical perspectives, referred to as the two "pillars".

1.16.2. ... based on two analytical perspectives ...

In the ECB's strategy, monetary policy decisions are based on a comprehensive analysis of the risks to price stability. This analysis is organised on the basis of two complementary perspectives on the determination of price developments. The first perspective is aimed at assessing the short to medium-term determinants of price developments, with a focus on real activity 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 (see also Section 4.4). The ECB refers to this as the "economic analysis". The second perspective, referred to as the "monetary analysis", focuses on a longer-term horizon, exploiting the long-run link between money and prices (see also Section 4.5). The monetary analysis serves mainly as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications for monetary policy coming from the economic analysis.

1.16.3. ... to ensure that no relevant information is lost

The two-pillar approach is designed to ensure that all relevant information is used in the assessment of the risks to price stability and that appropriate attention is paid to different perspectives and the cross-checking of information in order to come to an overall judgement of the risks to price stability. It represents, and conveys to the public, the notion of diversified analysis and ensures robust decision-making based on different

1.17.
Economic analysis

1.17.1. Analysis of short to medium-term risks to price stability ...

The economic analysis focuses mainly on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability. The economic and financial variables that are the subject of this analysis include, for example, developments in overall output; aggregate demand and its components; fiscal policy; capital and labour market conditions; a broad range of price and cost indicators; developments in the exchange rate, the global economy and the balance of payments; financial markets; and the balance sheet positions of euro area sectors. All these factors are helpful in assessing the dynamics of real activity and the likely development of prices from the perspective of the interplay between supply and demand in the goods, services and factor markets at shorter horizons (see also Section 4.4).

1.17.2. ... helps to reveal the nature of shocks ...

In this analysis, due attention is paid to the need to identify the origin and the nature of shocks hitting the economy, their effects on cost and pricing behaviour and the short to medium-term prospects for their propagation in the economy. For example, the appropriate monetary policy response to inflationary consequences of a temporary rise in the international price of oil might be different from the appropriate response to higher inflation resulting from the labour cost implications of wage increases not matched by productivity growth. The former is likely to result in a transient and short-lived increase in inflation which may quickly reverse. As such, if this shock does not lead to higher inflation expectations, it may pose little threat to price stability over the medium term. In the case of excessive wage increases, there is the danger that a self-sustaining spiral of higher costs, higher prices and higher wage demands may be created. To prevent such a spiral from occurring, a strong monetary policy action to reaffirm the central bank's commitment to the maintenance of price stability, thereby helping to stabilise inflation expectations, may be the best response.

To take appropriate decisions, the Governing Council needs to have a comprehensive understanding of the prevailing economic situation and must be aware of the specific nature and magnitude of any economic disturbances threatening price stability.

1.17.3. ... and includes macroeconomic projections

In the context of the economic analysis, the Eurosystem's staff macroeconomic projection exercises play an important role. The projections, which are produced by the staff , help to structure and summarise a large amount of economic data and ensure consistency across different sources of economic evidence. In this respect, they are a key element in sharpening the assessment of economic prospects and the short to medium-term fluctuations of inflation around its trend.

1.18. Monetary analysis

1.18.1. Money provides a nominal anchor

The ECB singles out money from within the set of selected key indicators that it monitors and studies closely. This decision was made in recognition of the fact that monetary growth and inflation are closely related in the medium to long run (see also Section 4.5). This widely accepted relationship provides monetary policy with a firm and reliable nominal anchor beyond the horizons conventionally adopted to construct inflation forecasts. Therefore, assigning money a prominent role in the strategy was also a tool to underpin its medium-term orientation. Indeed, taking policy decisions and evaluating their consequences not only on the basis of the short-term indications stemming from the analysis of economic and financial conditions but also on the basis of monetary and liquidity considerations allows a central bank to see beyond the transient impact of the various shocks and not to be tempted to take an overly activist course.

1.18.2. The reference value for monetary growth

In order to signal its commitment to monetary analysis and to provide a benchmark for the assessment of monetary developments, the ECB announced a reference value for the broad monetary aggregate M3 (see Box 5.9).This reference value (which was set to a value of 4½ % in 1998) refers to the annual rate of M3 growth that is deemed to be compatible with price stability over the medium term. The reference value therefore represents a benchmark for analysing the information content of monetary developments in the euro area. Owing to the medium to long-term nature of the monetary perspective, however, there is no direct link between short-term monetary developments and monetary policy decisions. Monetary policy does not therefore react mechanically to deviations of M3 growth from the reference value.

1.18.3. Analysis of special factors

One reason for this is that, at times, monetary developments may also be influenced by "special" factors caused by institutional changes, such as modifications to the tax treatment of interest income or capital gains. These special factors can cause changes in money holdings since households and firms will respond to changes in the attractiveness of bank deposits included in the definition of the monetary aggregate M3 relative to alternative financial instruments. However, monetary developments caused by these special factors may not be very informative about longer-term price developments. Consequently, monetary analysis at the ECB tries to focus on underlying monetary trends by including a detailed assessment of special factors and other shocks influencing money demand.

1.19. Cross-checking information from the two pillars

Regarding the Governing Council's decisions on the appropriate stance of monetary policy, the two-pillar approach provides a cross-check of the indications that stem from the shorter-term economic analysis with those from the longer-term oriented monetary analysis. As explained in more detail above, this cross-check ensures that monetary policy does not overlook important information relevant for assessing future price trends. All complementarities between the two pillars are exploited, as this is the best way to ensure that all the relevant information for assessing price prospects is used in a consistent and efficient manner, facilitating both the decision-making process and its communication (see Chart below). This approach reduces the risk of policy error caused by the over-reliance on a single indicator, forecast or model. By taking a diversified approach to the interpretation of economic conditions, the ECB's strategy aims at adopting a robust monetary policy in an uncertain environment.

1.20. Transparency and accountability

1.20.1. Reporting requirements imposed by the Treaty

To maintain its credibility, an independent central bank must be open and clear about the reasons for its actions. It must also be accountable to democratic institutions. Without encroaching on the ECB's independence, the Treaty establishing the European Community imposes precise reporting obligations on the ECB.

The ECB has to draw up an Annual Report on its activities and on the monetary policy of the previous and current year and present it to the European Parliament, the EU Council, the European Commission and the European Council. The European Parliament may then hold a general debate on the Annual Report of the ECB. The President of the ECB and the other members of the Executive Board may, at the request of the European Parliament or on their own initiative, present their views to the competent committees of the European Parliament. Such hearings generally take place each quarter.

Furthermore, the ECB must publish reports on the activities of the ESCB at least once every quarter. Finally, the ECB has to publish a consolidated weekly financial statement of the Eurosystem, which reflects the monetary and financial transactions of the Eurosystem during the preceding week.

1.20.2. Communication activities of the ECB

In fact, the ECB has committed itself to going beyond the reporting requirements specified in the Treaty. One example of this far-reaching commitment is that the President explains the reasoning behind the Governing Council's decisions in a press conference which is held immediately after the first meeting of the Governing Council every month. Further details of the Governing Council's views on the economic situation and the outlook for price developments are published in the ECB's Monthly Bulletin.

1.20.3. Relationship with EU bodies

A member of the European Commission has the right to take part in the meetings of the Governing Council and the General Council, but not to vote. As a rule, the Commission is represented by the Commissioner responsible for economic and financial matters.

The ECB has a reciprocal relationship with the EU Council. On the one hand, the President of the EU Council is invited to the meetings of the Governing Council and the General Council of the ECB. He may put forward a motion to be discussed in the Governing Council, but may not vote. On the other hand, the President of the ECB is invited to the meetings of the EU Council when the Council is discussing matters relating to the objectives and tasks of the ESCB. Apart from the official and informal meetings of the ECOFIN Council (which brings together the EU ministers for economic affairs and finance), the President also takes part in meetings of the Eurogroup (meetings of the ministers for economic affairs and finance in the euro area countries). The ECB is also represented on the Economic and Financial Committee, a consultative Community body which deals with a broad range of European economic policy issues.

1.21. Overview of the Eurosystem's operational framework

1.21.1. Operational framework

As mentioned before, the Governing Council decides on the level of key ECB interest rates. For these interest rates to feed through to firms and consumers, the ECB relies on the intermediation of the banking system. When the ECB changes the conditions at which it borrows from and lends to the banks, the conditions set by the banks for their customers, i. e. firms and consumers, are also likely to change. The set of Eurosystem instruments and procedures for transacting with the banking system, thereby initiating the process by which these conditions are transmitted to households and firms, is called the operational framework.

1.21.2. Main categories of instruments

Broadly speaking, the euro area banking system partly due to its need for banknotes but partly also because the ECB asks it to hold some minimum reserves on accounts with the NCBs has a need for liquidity and is reliant on refinancing from the Eurosystem. In this context, the Eurosystem acts as liquidity supplier and via its operational framework helps the banks to meet their liquidity needs in a smooth and well-organised manner.

The operational framework of the Eurosystem comprises three main elements. First, the ECB manages reserve conditions in the money market and steers money market interest rates by providing reserves to the banks to meet their liquidity needs through open market operations. Second, two standing facilities, a marginal lending facility and a deposit facility, are offered to banks to allow overnight loans or deposits in exceptional circumstances. The facilities are available to banks as and when they require, although borrowing at the marginal lending facility must be against eligible collateral. Third, reserve requirements increase the liquidity needs of banks. In addition, since they can be averaged over a period of one month, they can also act as a buffer against temporary liquidity shocks in the money market and thereby reduce the volatility of short-term interest rates.

1.21.3. Open market operations

Open market operations the first element of the operational framework are conducted in a decentralised manner. While the ECB co-ordinates the operations, the transactions are carried out by the NCBs. The weekly main refinancing operation is a key element in the implementation of the ECB's monetary policy. The official interest rate set for these operations signals the stance of the monetary policy decided by the Governing Council of the ECB. The longer-term refinancing operations are also liquidity-providing transactions, but are conducted monthly and have a maturity of three months. Fine-tuning operations are executed on an ad hoc basis to smooth the effects on interest rates of unexpected liquidity fluctuations or extraordinary events.

The criteria for counterparty eligibility in the Eurosystem's operations are very broad: in principle, all credit institutions located in the euro area are potentially eligible. Any bank may choose to become a counterparty if it is subject to the Eurosystem's reserve requirements, is financially sound, and fulfils specific operational criteria enabling it to transact with the Eurosystem. Both the broad counterparty criteria and the decentralised operations are formulated to ensure equal treatment for all institutions across the euro area so they may participate in the operations carried out by the Eurosystem and are conducive to an integrated primary money market.

The open market operations of the Eurosystem are conducted as repurchase agreements ("repos") or as collateralised loans. In both cases, short-term loans from the Eurosystem are granted against sufficient collateral. The range of eligible collateral in the operations is very wide, including public and private sector debt securities, to ensure an abundant collateral base for counterparties across euro area countries. Moreover, eligible assets can be used across borders. The open market operations of the Eurosystem are organised as auctions to ensure a transparent and efficient distribution of liquidity in the primary market.

An overriding feature of the operational framework is the reliance on a self-regulating market, with the infrequent presence of the central bank. The money market interventions of the central bank are generally limited to the main refinancing operations which take place once a week and the much smaller longer-term refinancing operations which take place once a month. Fine-tuning operations have been rather infrequent in the first years of the ECB.

1.21.4. Standing facilities and reserve requirements

The two major instruments complementing the open market operations the standing facilities and the reserve requirements are applied mainly to contain volatility in short-term money market rates.

The rates on the standing facilities are usually significantly less attractive than the interbank market rates (+/- one percentage point from the main refinancing rate). This gives banks an important incentive to transact in the market and only use standing facilities when other market alternatives have been exhausted. Since banks always have access to standing facilities, the rates on the two standing facilities provide a ceiling and a floor by market arbitrage for the overnight market interest rate (the so-called "EONIA"). The two rates therefore determine the corridor in which the EONIA can fluctuate. In this context, the width of the corridor should encourage the use of the market. This adds an important structure to the money market which limits the volatility of very short-term market rates (see Chart below).

A bank's reserve requirements are determined as a fraction of its reserve base, a set of liabilities on its balance sheet (deposits, debt securities and money market papers with a maturity of less than two years).

The reserve requirement system specifies banks' required minimum current account holdings with their NCB. Compliance is determined on the basis of the average of the daily balances over a period of around one month (called the "maintenance period"). The averaging mechanism provides inter-temporal flexibility to banks in terms of managing reserves across the reserve maintenance period. Temporary liquidity imbalances do not need to be covered immediately and, consequently, some volatility in the overnight interest rate can be smoothed out. (If, for instance, the overnight rate is higher than the expected rate later in the reserve maintenance period, banks can make an expected profit from lending in the market and postponing the fulfilment of required reserve holdings until later in the period ("inter-temporal substitution"). This adjustment of the daily demand for reserves helps to stabilise interest rates.)

The holdings of required reserves are remunerated at the average tender rate in the main refinancing operations over a maintenance period. This rate is virtually identical to the average interbank market rate at the same maturity. Reserves held at the banks' current accounts in excess of the monthly requirement are not remunerated. This gives banks an incentive to manage their reserves actively in the market. At the same time, the remuneration of required reserves avoids the risk of the reserve requirement being a burden on banks or hampering the efficient allocation of financial resources.

The required reserves act as a buffer against liquidity shocks. Fluctuations in reserves around the required level can absorb liquidity shocks with little impact on market interest rates. Therefore, there is little need for extraordinary intervention by the central bank in the money market to stabilise market rates.

1. Money ­a short history