ECB and Inflation

What tries Mr. Monti to do concerning inflation?

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Policy strategy of the ECB

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Transmission process

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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

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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)

Ci = the amount of good i in the CPI’s basket

Pit = the price of good i in month t

Et = the cost of the CPI basket in month t

Eb = the cost of the basket in the base period6

Understanding the Index

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t

b

ECPI in month

Et 1t 1 2t 2 3t 3

b

P C + P C + P C

E

31 21t 2t 3t

b b b

CC CP P P

E E E

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

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The European CPIHICP

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In comparisonThe U.S CPI’s “basket”

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Exercise: Compute the CPI

Basket contains 20 pizzas and 10 compact discs.

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prices:

pizza CDs

2002 €10 €15

2003 €11 €15

2004 €12 €16

2005 €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:

Year Cost of CPI Inflationbasket rate

2002 €350 100.0 n.a.

2003 €360 %

2004 €400 %

2005 €420 %

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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.

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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 !

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A step further:Inflation and interest rates

Two different interest rates

• Nominal interest rate, inot adjusted for inflation

• Real interest rate, radjusted for inflation:

r = i

Real interest rate r is the growth (or shrink) in purchasing power !

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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

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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?

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Inflation and nominal interest rates in the U.S., 1955-2006

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percent per year

-5

0

5

10

15

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

inflation rate

nominal interest rate

Inflation and nominal interest rates across countries

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1

10

100

0,1 1 10 100 1000

Nominal

Interest Rate(percent, logarit

hmic scale)

Inflation Rate(percent, logarithmic scale)

1

10

100

0,1 1 10 100 1000

Nominal

Interest Rate(percent, logarit

hmic scale)

Inflation Rate(percent, logarithmic scale)

Switzerland

Germany

Brazil

Romania

Zimbabwe

Bulgaria

U.S.

Israel

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A few examples of hyperinflation

Examples for hyperinflation

money growth (%)

inflation (%)

Israel, 1983-85 295 275

Poland, 1989-90 344 400

Brazil, 1987-94 1350 1323

Argentina, 1988-90 1264 1912

Peru, 1988-90 2974 3849

Nicaragua, 1987-91 4991 5261

Bolivia, 1984-85 4208 6515

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

Nominal GDP

GDP deflator = 100Real GDP

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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 2008.

Nom. GDP Real GDPGDP

deflatorInflation

rate

2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

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Answers to practice problem, part 2

Nominal GDP

Real GDPGDP

deflator

Approx. Inflation

rate

2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%

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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

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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.

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Excursion: Practice problem (1)

• Compute nominal GDP in each year.

• Compute real GDP in each year using 2006 as the base year.

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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.

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