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Who is responsible for fighting inflation?


Published: 23 March 2023

ECB gebouw

Central banks were created specifically to ensure stable prices and intervene when needed. Why do we need price stability, and why do many people think this is the government’s responsibility?

A large majority of Dutch people (73%) believe that fighting inflation is a government task.  This was revealed in a recent survey to find out what people think about the work of central banks. Some 38% think that fighting inflation in the Netherlands is a task of De Nederlandsche Bank (DNB), and 53% see it as the responsibility of the European Central Bank (ECB). But whose responsibility is it?

Those who think this responsibility lies with the ECB are right. It is the ECB that is responsible for fighting inflation in the euro area, including the Netherlands, and not the government. DNB does have a role to play, but we’ll explain that later.

Independent decisions...

First, there is the question of why we need an independent central bank. Society benefits greatly from a reliable, stable currency that maintains its value. We must be confident that the euros in our wallets and bank accounts will allow us to do our grocery shopping tomorrow, the day after tomorrow and five years from now.

This means it is important that the party in charge of ensuring stable prices can make independent decisions – without political considerations, such as an upcoming election, playing a role. 

.... to ensure a well-functioning economy

Keeping inflation under control is a long-term process. And it would not be a good thing if monetary policy were to have some other, more political purpose in addition to its primary focus on inflation targeting. That is why central banks have been given the power to take decisions independently, with the ultimate goal of ensuring a well-functioning economy. Regulations stipulates that the ECB or national central banks such as DNB may not seek or receive instructions from Member State governments, EU bodies or anyone else. This political independence allows the central banks to focus entirely on their mission: price stability.

Why do central banks raise interest rates?

Inflation is mainly a matter of supply and demand, as we learned in school. When demand increases because more people want the same product, the price goes up. Prices also go up when supply is limited. So to get rid of the current high inflation, we need to look at the demand side as well as the supply side of our economy.

Unfortunately, there is no simple way to fix the supply problems that have led to the current high energy and commodity prices, but central banks can take measures to moderate high demand in order to curb inflation. For example, they can raise interest rates to bring down demand for products. 

How does this work?

Interest rates, and specifically the policy rate, are the main tool of central banks. By setting the policy rate, the ECB determines how expensive it is for commercial banks to borrow money. Those rates in turn affect banks’ lending and savings rates for consumers and businesses. When interest rates are higher, borrowing money is more expensive and consumers and businesses have less to spend.

This ultimately depresses economic demand and prices, which is also referred to as cooling of the economy It always takes time for interest rate adjustments to affect prices. That is why the first effects of the ECB’s measures to normalise its policy, which started in December 2021, are only now becoming visible.

What is the role of DNB?

The ECB’s Governing Council, which includes the ECB's Executive Board and the central bank Governors of the 20 euro countries, sets the policy rate. It meets every six weeks on monetary policy for the euro area, and Klaas Knot, as DNB's President, also has a say.

And what does the government do?

The government does not interfere in monetary policy, even though many people think they do. That is not very surprising, since high inflation has a huge impact on our purchasing power. How we deal with this, is up to politicians. For example, the government may decide to compensate loss of purchase power by providing targeted support to citizens and businesses that cannot afford high energy bills.

In doing so, government policy does sometimes touch on central bank policy. Financial support from the government means people have more to spend. If this leads to more demand for products, prices will rise again. And that's where we as a central bank come in again. To slow down demand, we raise interest rates. It doesn't help if government policies then make demand grow again. If we want our efforts to be effective, we must avoid government and central bank measures working against each other. We are therefore monitoring this closely, and if we see any risks in this area, we provide economic advice to the government.

Other parties that play a role

When people suffer a loss of purchasing power due to inflation, they will look for ways to increase their income. Higher wages are the most direct response to loss of purchasing power. Employers therefore have an important role to play. If they pay higher wages, they may have to pass on the costs in the prices of their products and services, however. And then workers will demand even higher wages to maintain their purchasing power. This economic phenomenon is referred to as a wage-price spiral. Controlled wage growth can help to prevent this. At present we do not see a wage-price spiral situation.

In deze infograpic wordt uitgelegd hoe een loon-prijsspiraal kan ontstaan. Doordat prijzen stijgen, willen werknemers meer loon, maar wanneer de lonen stijgen, stijgen de kosten voor bedrijven ook. Dit zorgt ervoor dat bedrijven hun prijzen verhogen waardoor de prijzen voor consumenten vervolgens opnieuw zullen stijgen. Dit noem je een loon-prijsspiraal.

Balancing act

Finding the most effective way to fight inflation and absorb the loss of purchasing power requires striking a balance on many levels, together with the various parties that are each taking their own measures. In any case, it is clear that it is the European Central Bank that independently safeguards the value of the euro. It is also clear that we all have our own role to play in keeping prices stable. And it is even more clear that these different roles are very important and can interact, but that we all have the same objective: to bring inflation back down.

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