Beginners Handbook

How can the ECB control inflation?

To keep inflation under control, central banks supervise, regulate and intervene in the process of money creation, to ensure there is enough money in the system to help the economy, but not too much either. 

Inflation raises too much when there is too much money in the economy chasing too few goods and services. Inflation illustrates a situation when the economy is “overheating” because factories, production processes and labor are not able to respond fast enough to the rise in purchasing power of people. As a result, instead of running out of stock too quickly, companies tend to raise their prices. When this happens in all or most sectors of the economy, this results in excessive inflation. 

In a simplified world, inflation happens when there is too much money created and circulating in the economy. But the ECB does not control prices directly. Nor does it control the money supply directly; the bank notes that it issues only constitute a very small proportion of the money supply, and are usually produced in response to demand. 

Most of the money in the economy today is actually created by private commercial banks making loans. While the central bank is the only institution that can actually print physical money, almost all digital money in circulation either originates as loans issued by the private banking sector and which exists as digital deposits in commercial bank accounts.

What the ECB does control are the key interest rates at which private commercial banks can obtain money, or liquidity, from their national central banks when they do not have enough money for their customers. By adjusting its interest rates, the ECB indirectly influences the rates charged by the commercial banks to its customers, which regulates the flow of money that is created by commercial banks when they make loans.

When the ECB is faced with rising inflation, it will typically raise the interest rate, which in turn will limit the commercial banks’ incentive to borrow money, thus curbing money supply. Higher interest rates also encourage savings. As more money is in the bank, and less in circulation, demand for products drops, and prices fall.

Conversely, in a situation of deflation, the ECB will lower its interest rate to counter a fall in prices. Lower interest rates encourage more demand through both consumption and investment. In this way, the ECB controls inflation and deflation, and ensures that there is always a correct amount of money in circulation.

“Monetary policy” refers to the actions undertaken by a central bank to achieve its price stability objective. The next section elaborates on what monetary policy tools the ECB currently uses.