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Monetary policy: what is it and how does it work?
The main objective of the European Central Bank (ECB) is price stability. This means that prices should not rise too much (inflation), increase too slowly, or even go down too much (deflation). To achieve this, the ECB takes measures. This is what we call monetary policy.
A long time of low inflation and low interest rates
The ECB wants inflation to be below but close to 2% per year in the medium term. But the prices of products and services have been rising less than this target value for years. This is mainly due to structural causes beyond the ECB's sphere of influence, such as globalisation and digitisation. The reduced demand for goods and services led to a further fall in inflation during the coronavirus crisis. The exact impact of the coronavirus crisis on inflation is still unclear.
What measures does the ECB take to keep prices stable?
The ECB has no direct influence on rising and falling prices, but it does have tools to influence inflation indirectly, namely monetary instruments. There is a difference between conventional monetary instruments – such as policy interest rates – and unconventional instruments – such as purchase programmes .
What is accommodative monetary policy?
The ECB pursues accommodative monetary policy – also known as quantitative easing – when it tries to stimulate the economy by providing low interest rates for households, businesses and governments. It does so, for instance, during a recession as currently with the coronavirus crisis. For this, the ECB relies on its interest rate instrument and purchase programmes.
How does the interest rate instrument work?
The ECB influences interest rates on the money market with its official policy rates. These are the interest rates that banks pay to the ECB when they borrow money or hold money on deposits. Under normal conditions, the key policy rates are the accelerator and brake pedals of the economy.
Increasing interest rates
Higher interest rates make it more expensive to borrow money. As a result, consumers and businesses spend less money. And that puts a brake on the economy, so that prices will rise less rapidly.
Lowering interest rates
Lower interest rates make it cheaper to borrow money. This should encourage consumers and businesses to buy and invest more. In turn, that should lead to higher prices and stimulate the economy. But although interest rates have been low for years, inflation has also remained low.
How do purchase programmes work?
In purchasing programmes, the ECB and the central banks of the euro area (the Eurosystem) purchase bonds from market participants, reducing market rates. As a result, lending and spending are increased, which leads to economic growth. Examples include the asset purchase programme (APP) and the pandemic emergency purchase programme (PEPP). The latter was launched in March 2020 in the wake of the coronavirus crisis.
What is money creation?
As a result of the accommodative monetary policy, demand for credit is increasing. Banks play an important role in the provision of credit. That is how money is created. Watch the video to see exactly what money creation is and how it works.
ECB discusses monetary policy
The ECB wants to know what euro area residents think of its monetary policy. The aim is to find out how it can best perform its main task of ensuring a low and stable inflation rate in the euro area. In this light, the ECB is reviewing the instruments it uses for this purpose, such as interest rates and the purchase of bonds. But also which inflation rate – the rate with which prices rise – it should pursue. For this review of its policy strategy, the ECB is engaging with people across Europe, with residents, academics, Members of the European Parliament, representatives of the financial sector and civil society organisations. As part of the European System of Central Banks, DNB also started a dialogue with Dutch citizens and civil society organisations on 26 November 2020.
What is the role of DNB and the ECB?
The ECB takes measures for the euro area and all its central banks. Klaas Knot is DNB’s President and has a seat on the ECB’s Governing Council. Staff from different DNB departments advise Klaas Knot in this field and also participate in various international consultative bodies.