The European Central Bank, ECB, is a financial institution that ensures that inflation remains stable at around 2%. In other words, a constant price increase of around 2%, which it considers to be a reflection of a well-functioning economy. Today, inflation is around 0%. The ECB will therefore ensure that prices are increased
How can the ECB raise prices?
In order to increase prices, the European Central Bank can increase the amount of money in our economy. It thus influences the supply and demand for products. The more money in circulation, the more households are able to consume goods and services easily. Demand for these goods and services therefore increases at the same time as prices rise in order to reduce their supply.
How is money injected into the economy?
None other than banks are best qualified to inject money into our economy. Indeed, when a bank provides low-interest loans to businesses and individuals, the latter are in a better position to borrow money. In addition, when a loan is granted, the bank in question creates currency that it does not have through a simple accounting entry. This currency then circulates in our economy.
To raise prices, the ECB therefore seeks to encourage banks to lend money at low rates to encourage businesses and individuals to borrow. This process helps to boost a country’s economy. In order to allow banks to grant low interest rates, the ECB first lowers its key interest rate, i.e. the rate at which it lends money to banks.
Today, although the ECB’s key interest rate is close to 0%, credit is not resuming. A new lever is therefore used by the ECB called Quantitative Easing. Quantitative Easing consists in increasing banks’ liquidity by buying back, on favourable terms, their government bonds. As a low-risk investment, banks buy a lot of government bonds. These bonds are therefore bought back by the ECB to replenish their cash reserves. If this liquidity is then used to lend to individuals and businesses, the resumption of borrowing should theoretically raise the inflation rate.
Over the medium term, the sustained low interest rates combined with rising prices should push businesses and individuals to borrow. Indeed, it is very beneficial to borrow money from banks when an economy is inflated because the interest rate actually paid, called “Real Interest Rate”, is calculated by making the difference between the interest rate and the inflation rate.
The European Central Bank wants to restore its inflation rate to close to 2% thanks to quantitative easing, leading to the recovery of credit, investment and, as a result, growth.
However, these banks must use this liquidity for good purposes and in particular to promote credit. All economic agents must also regain confidence in the situation they are facing.