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Monetary policy

Primary objective

The primary objective of the ECB's monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.

Quantitative definition of price stability: The ECB's Governing Council has defined price stability 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".

To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1). The Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These include a "high level of employment" and "sustainable and non-inflationary growth".

The Treaty establishes a clear hierarchy of objectives for the Eurosystem and assigns overriding importance to price stability. The ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.

These Treaty provisions reflect the broad consensus that the benefits of price stability are substantial. Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy. The natural role of monetary policy in the economy is to maintain price stability. Monetary policy can affect real activity only in the shorter term, but ultimately it can only influence the price level in the economy.

Scope of monetary policy

The central bank is the sole issuer of banknotes and bank reserves. That means it is the monopoly supplier of the monetary base. By virtue of this monopoly, it can set the conditions at which banks borrow from the central bank. Therefore it can also influence the conditions at which banks trade with each other in the money market, i.e. liquidity development and money market interest rates.

In the short run, a change in money market interest rates induced by the central bank sets in motion a number of mechanisms and actions by economic agents. Ultimately the change will influence developments in economic variables such as output or prices. This process - also known as the monetary policy transmission mechanism - is highly complex. While its broad features are understood, there is no consensus on its detailed functioning.

Long-run neutrality of money

It is widely agreed that in the long run - after all adjustments in the economy have worked through - a change in the quantity of money in the economy will be reflected in a change in the general level of prices. But it will not induce permanent changes in real variables such as real output or unemployment. Real income or the level of employment are, in the long term, essentially determined by real factors, such as technology, population growth or the preferences of economic agents.

Inflation - a monetary phenomenon

In the long run a central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices. It cannot enhance economic growth by expanding the money supply or keeping short-term interest rates at a level inconsistent with price stability. It can only influence the general level of prices. Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth. 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 offset by a change in monetary policy.

Transmission mechanism of monetary policy

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level.