ECB and Inflation What tries Mr. Monti to do concerning inflation? 1

Policy strategy of the ECB 2

Transmission process 3

Instruments of the ECB

A bit more about inflation Measuring Inflation The Governing Council of the ECB announced the following quantitative definition in 1998 (2003): “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 (close to) 2 %. Price stability is to be maintained over the medium term” → €-Area-wide 5

Construction of the tools to measure inflation Harmonized Index of Consumer Prices This is one instrument to measure a specific inflation, but not the only one. Example with 3 goods (good i = 1, 2, 3) C i = the amount of good i in the CPI’s basket P it = the price of good i in month t E t = the cost of the CPI basket in month t E b = the cost of the basket in the base period 6

Understanding the Index 7 The weight on each price reflects that good’s relative importance in the CPI’s basket. Note: the weights remain fixed over time. But the weight and products in the basket will be adjusted every 5-6 years.

Composition of the CPI in the EU - HICP 8

The European CPI HICP 9

In comparison The U.S CPI’s “basket” 10

Exercise: Compute the CPI Basket contains 20 pizzas and 10 compact discs. 11 prices: pizzaCDs 2002€10€ €11€ €12€ €13€15 For each year, compute the cost of the basket the CPI (use 2002 as the base year) the inflation rate from the preceding year

Answers: YearCost of CPIInflation basketrate 2002€ n.a. 2003€360 % 2004€400 % 2005€420 % 12

ECB – Their aims and instruments The aggregate the ECB uses to target inflation is M3 M3 comprises M2 & certain marketable instruments (mostly) issued by the banking sector. These marketable instruments are repurchase agreements, money market fund shares/units & debt securities with a maturity of up to 2 years (including money market paper). A high degree of liquidity & price certainty make these instruments close substitutes for deposits. F. Girod – PLA 12 (2009) 13

Seigniorage Earning money by printing it? To spend more without raising taxes or selling bonds, the government can print money. The “revenue” raised from printing money is called seigniorage The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a tax on people who hold money. 14

Long run vs. short run For discussion: Concerning the policy of the ECB, how could we explain differences in the correlation of inflation and money growth rate in the long and short run?  In the short run inflation and money growth rate are often negatively correlated ! 15

A step further: Inflation and interest rates Two different interest rates Nominal interest rate, i not adjusted for inflation Real interest rate, r adjusted for inflation: r = i    Real interest rate r is the growth (or shrink) in purchasing power ! 16

The Fisher effect Link between the two interest rates The Fisher equation: i = r +  S(avings) = I(nvestments) determines r - therefore independent from Inflation. Determined by real Returns on investment Hence, an increase in  causes an equal increase in i (on the long run) This one-for-one relationship is called the Fisher effect (FE). The FE implies that CHANGES in the nominal interest rate equal CHANGES in the inflation rate, given a constant value of the real interest rate 17

Be aware ! Attention: The ECB is not following this “Fisher effect” !  The ECB acts independent, based on their expectations, but on the long run (e.g. years) the decisions of the ECB will not effect the real interest rate.  Makes sense ! Why should the ECB policy affect a long-term investment of Siemens for instance? 18

Inflation and nominal interest rates in the U.S., percent per year inflation rate nominal interest rate

Inflation and nominal interest rates across countries 20 Switzerland Germany Brazil Romania Zimbabwe Bulgaria U.S. Israel

21 A few examples of hyperinflation Examples for hyperinflation money growth (%) inflation (%) Israel, Poland, Brazil, Argentina, Peru, Nicaragua, Bolivia,

GDP Deflator The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP deflator, defined as 22

Practice problem, part 2 Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to Nom. GDPReal GDP GDP deflator Inflation rate 2006$46,200 n.a ,40050, ,30052,000 23

Answers to practice problem, part 2 Nominal GDP Real GDP GDP deflator Approx. Inflation rate 2006$46, n.a ,40050, % ,30052, % 24

Excursion Real variables: Measured in physical units – quantities & relative prices, e.g.: quantity of output produced real wage: output earned per hour of work Nominal variables: Measured in money units, e.g.: nominal wage: Dollars per hour of work. nominal interest rate: Dollars earned in future by lending one dollar today. the price level: The amount of dollars needed to buy a representative basket of goods 25

Excursion: Real vs. nominal GDP GDP is the value of all final goods and services produced. nominal GDP measures these values using current prices. real GDP measure these values using the prices of a base year. 26

Excursion: Practice problem (1) Compute nominal GDP in each year. Compute real GDP in each year using 2006 as the base year. 27

Excursion: Real GDP controls for inflation Changes in nominal GDP can be due to: changes in prices. changes in quantities of output produced. Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. 28