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Price stability and monetary policy

 Price stability creates conditions for economic growth

The function of the national central banks in the euro area is to ensure that inflation, i.e. the increase in the price level, is just below 2% over an average period of time. This creates the conditions necessary for economic growth. Price stability is also a crucial part of the stability of the economic environment. The more stable the rise in the price level, the more capable companies and people are of making reasonable economic decisions from the point of view of their future plans and salary requests.

A small change in the price level is useful for the economy. On the other hand, excessive rises in the price level, price decreases or steady price levels are not as useful. There are several reasons for this.

  • The ideal condition is when the economy has as little uncertainty as possible. A constant slow increase in the price level and knowing what inflation rate has been set as the objective by the central bank contributes to this. Thus, consumers and manufacturers do not have to worry too much about the change in the purchasing power of money (the quantity of goods that can be purchased for a currency unit). They can calculate more precisely how much the purchasing power of money will increase as a result of the interest earned on savings and how much it will decrease due to inflation.

  • A small price increase contributes to the efficient use of money. In order to avoid a decrease in the purchasing power of money, it is practical for the holder of the money to direct it back into circulation. This means that the money holder searches for saving options that are as sound as possible or consumes various products and services.

  • If the price level does not change at all, there is a risk that even a very small decrease in economic activity may lead to a decline in prices. This causes a significant change in expectations of consumers: while waiting for a further decrease in prices, they postpone their consumption and investment decisions, causing a further fall in prices. However, the postponed purchases mean houses are not built, cars are not manufactured etc. – that is, growth in unemployment. Therefore, the unemployment rate is generally higher when the price increase or decrease is lower than expected.

In developed countries the task of maintaining price stability is entrusted to central banks independent of the government and separated from policy. History has shown that politicians cannot cope with maintaining price stability very well. There are always things on which they want to spend to please their constituency and which are financed by printing more money. This creates excessive inflation and worsens economic stability and, as a result, the well-being of society. 

National central banks influence price stability through interest rates, quantity of money and exchange rates, favouring economic activities and, thereby, a general increase in prices. This is called monetary policy.

 Actions in the economy affect prices

Several factors affect the formation of prices. For most countries, external factors are of primary importance. This means that some prices are formed on the world market as a result of demand and supply. For instance, oil influences almost all countries but very few can directly affect the price of oil. Thus, if the price of oil increases globally, this carries over to prices in Estonia as a small country with an open economy. Global price formation does not only concern commodities, but also many foodstuffs.

In addition to external factors, the price level is also influenced by local economic environment. This mainly applies to goods and services that cannot be exported. For example, the price list of a hair salon in Tartu is independent of the prices of a hair salon in London. A hairdresser must take into account the ability of locals to pay for their services, because people generally use such a service in their home area and will not travel abroad for this purpose. Thus, it must be considered for most services that service sector prices are mostly influenced by local factors, especially the local salary level. For instance, if salaries increase and there is a risk that the present salary will not keep employees in their job, an owner of a hair salon is required to raise the salaries of its workers and accordingly change the price list of the salon.

Prices react to actions in the economy with a certain delay. For example, if the oil price rises, this may not be reflected in the price lists of restaurants immediately. Although restaurants use fuel to transport their foodstuffs, the spread of the impact of an abrupt price increase takes time. In the event of a price increase in foodstuffs, a restaurateur may hold off on changing prices for several reasons. One of the reasons is competition – the first to change their prices will lose clients. Therefore, many companies do not raise the prices of their products and services if expenses increase only a little. But prices are often fixed in long-term contracts. The price of labour, i.e. salaries, is also generally fixed. It is impossible to ask for a raise every time petrol stations increase the price of fuel. The price increase is frequently limited by the use of so-called price temptations in price lists: a lot of buyers feel that there is a big difference between paying 9.99 and 10.01. If merchants do not take into consideration the buyer’s psychology and prefer to add a couple of cents to prices, they may experience greater losses than if they had covered the cost of a mere couple of cents themselves.

Prices are to a considerable extent affected by people’s inflation expectations, i.e. how big the price increase is expected to be by individuals in the near future. The greater the trust in a stable low price increase, the harder it is for merchants to raise the prices of their products and services – people are not prepared to pay more. The inflation expectations of people are also directly influenced by the activities of the central bank or, to be more specific, the ability of the central bank to maintain inflation at the stable, agreed level. In their analyses, central banks usually explain the factors that affect inflation and present inflation forecasts to the public.

 Inflation has an impact on human behaviour

Companies, governments and people need estimates of inflation that are as accurate as possible. Decisions made in policy and business, but also in daily life, directly or indirectly depend on how accurately inflation can be measured. For instance, it helps companies decide whether and when a new plant should be constructed that provides people with new jobs, governments to calculate within the framework of their budget whether they should build 100 or 98 km of new roads, and people to consider when to buy a new TV set.

Inflation is usually measured on the basis of the consumer price index (CPI). The consumer price index reflects changes in the cost of a typical shopping basket. The basket includes all of the goods and services consumed by an average consumer in a year. The price of a product in the basket is monitored each month. The shopping basket differs by country: proportionally more income is spent on food in poorer countries; the share of heating costs is greater in countries with colder climates; services are used to a greater extent in wealthier countries etc.

 Central banks determine the cost of money

Monetary policy decisions pertaining to the euro are taken (i.e. the cost of money is set) by the governors of central banks in Frankfurt at the beginning of each month when the meeting of the Governing Council of the European Central Bank is held. The most important duty of the Governor of Eesti Pank is to be thoroughly prepared for this meeting and for taking the decision. The governors of each national central bank have a vote with identical weight. The decisions made by the Governor of Eesti Pank in Frankfurt concern 17 countries and 331 million people – the number of people using the euro in daily transactions in the euro area. Thus, the decision must support the development of the euro area as a whole. If the euro area is doing well, Estonia and the other states in the euro area also do better.

Interest rates set by the governors of the central banks in the euro area form the cost of money. The cost at which commercial banks can borrow money from a central bank depends on interest rates. This also directly influences the interest rates of loans granted to companies and households. If banks receive money from the central bank at a lower interest rate or less expensively, the cost of money is less expensive for a companies and this encourages them to take out bigger loans, which also helps the economy recover. And, of course, vice versa – higher interest rates or more expensive money cools the economy. Through this the central bank is able to manage price stability and direct economic development.

In addition to the regular meetings and decision-making processes of the governors of central banks, there are also committees and working parties that operate in order to implement the decisions of the Governing Council. The committees and working parties include representatives of all of the central banks in the euro area. They are professional experts exchanging experience, trying to find solutions to problems, developing project implementation possibilities and, thereby, closely cooperating with one another. This ensures that the best experts in the euro area are involved in all of the processes, and upon adopting decisions the experience of all countries is followed.

Therefore, decisions related to the euro area are taken centrally and their implementation is a function of each national central bank. For instance, the conditions and amount of loans granted to banks is decided jointly, but the duty of each national central bank is to communicate with local banks wanting to take out loans. By providing commercial banks with an opportunity to borrow money from and deposit funds with the central bank, the latter develops and stabilises money market interest rates. The need to make transactions through a central bank abruptly increases during recessions when banks trust each other less.

To enable the Governor of Eesti Pank to take well-considered and grounded decisions, the Governor needs detailed overviews of the economic situation as well as forecasts of potential trends in the economy. For this purpose, experts from Eesti Pank draw up economic analyses and forecasts addressing both Estonia and the euro area.

 Economic analyses of Eesti Pank assist companies in planning their future

Although it is very hard to precisely foresee what will happen in the economy, there are general patterns. For example, it is known that a decrease in interest rates reduces saving, because the fee (i.e. the interest paid for money deposited with a bank) is too low. At the same time, the decrease in interest rates promotes borrowing, as low loan interest rates make borrowing easier for companies and they can invest more.

The detailed study of the patterns described above is one of the main functions of economists. It is only possible to experiment in economic science to a limited extent, because experimenting with the national economy may considerably affect the well-being of several generations if it fails. Thus, it is crucial that events that have occurred and potential future trends are analysed in detail by using mathematical models.

Knowledge of the economy allows us to analyse the impact of different economic policy steps and assess the future prospects of the economy. All such analyses, estimates and forecasts are nevertheless approximate. As the economy is constantly changing, the extent and the size of impact of economic laws also constantly changes. It must also be taken into account that the economy is influenced by the behaviour of all companies and individuals. Therefore, economic development is always associated with a certain degree of vagueness.
Economic analyses and forecasts represent the understanding of economic experts of what is going on in the economy and how it could develop further. These are based on facts available during the preparation of the analyses. Significant analyses and forecasts often contain risk scenarios that take into account potential unexpected events and assess their consequences. Eesti Pank draws up economic analyses and forecasts to enable people and companies to assess different risks and make their economic decisions in as considered a way as possible.

The central bank and government take decisions relying on economic analyses, impact assessments and forecasts. If necessary, central banks amend monetary policy. To this end, interest rates and the quantity of money in circulation are changed or exchange rates are influenced.

Eesti Pank publishes forecasts on the Estonian economy twice a year: in June and December. In addition, Estonian economic experts participate in the preparation of euro area forecasts. The bank forecast is completed in cooperation with experts from the Economics and Research Department, Financial Stability Department and International and Public Relations Department.

 Interesting facts

Examples of failure of monetary policy

Monetary policy means keeping inflation under control, which is usually done by central banks by establishing interest rates. Hyperinflation is when inflation is higher than 50% per month. In the event of hyperinflation, the value of money does not decrease over a period of years, but months, weeks or even hours. The quantity of money in circulation abruptly grows, because more and more is printed. People try to make purchases as soon as they obtain money to avoid a situation where the value of their money decreases and savings become worthless. Some facts about hyperinflation are presented below.

  • Hyperinflation is usual if disorder dominates in a country. Disorder may be caused by war, political instability or other major problems in society.
  • Hyperinflation, especially at its peak, is generally short-lived.
  • The black economy flourishes, economic processes become stunted, a lot of barter deals are made (goods being exchanged for goods) and social instability increases during hyperinflation.
  • Hyperinflation is characterised by a phenomenon that banknotes with a denomination of a million, billion or even more are in circulation. Paper currency becomes waste paper in a short space of time.
  • There is no single rule to end hyperinflation, but it usually requires the achievement of stability in society, the recovery of the functions of the state and monetary reform.

Germany 1922–19231

The greatest economic crisis in Germany during the period between the two World Wars revealed itself through hyperinflation, which came to a head in 1923. It started in 1922 and is thought to have arisen from Germany’s defeat in World War I. Some historians consider that the conditional cause of the hyperinflation was the assassination of Walther Rathenau, the Foreign Minister of Germany at the time, on 24 June 1922. This event unleashed discontent and instability in society.

Prices started to suddenly rise and people’s trust in money quickly vanished. To offload money, anything – musical instruments, cosmetics, pipes – was rapidly purchased. People received salaries many times a day, delivered in trucks. After the receipt of a bag of bankrolls, people ran to stores to spend it, because by the end of the business day they would get nothing much for the money. Children played with money that had become worthless; it was used to start fires, and glued on walls instead of wallpaper. Crime also flourished, the black market triumphed and foreigners felt like kings when possessing foreign currency.

By the end of 1923, inflation had reached billions of percent per month. Banknotes with a denomination of more than one trillion were issued. This chaos was terminated by a new currency, which was introduced in November 1923. This was no better secured than previously, but people’s faith and hope in an improvement in the situation was so great that the circumstances changed overnight.

Hungary 1945–1946

The Hungarian hyperinflation was a smaller talking point, but it was actually worse than that of Germany. Within 13 months the price level increased 3 × 1025 times, i.e. thirty septillion (30 and 24 zeros).

Hungary’s largest printed banknote – with the biggest denomination in world history – was 1021 pengő, the currency at the time. In other words, the nominal value of the banknote was one sextillion (1 and 21 zeros). The counting of these zeros would have been difficult even for a person who was good at mathematics and, thus, a prefix was added to the old currency twice during the period of hyperinflation. For example, mil-pengö meant that the old denomination must be multiplied by one million.

Since then no country has printed a banknote worth more than 100 trillion. There have been new starts with new currencies, but the value thereof often diminished just as quickly.

Yugoslavia 1993–1995

The hyperinflation in Yugoslavia was caused by a huge budget deficit, instability in the region arising from the collapse of the country and international embargos (prohibitions on trade in goods).

By the beginning of the 1990s the country had exhausted its foreign currency reserves and hyperinflation took hold. From 1993-1995 prices rose by 5 × 1015 percent, i.e. five quadrillion (5 and 15 zeros). The biggest banknote was 500 billion dinars, which circulated in 1993, but principally zeros were removed from banknotes and the situation continued.

As fuel was no longer being sold in the country, city buses were so overcrowded that ticket collectors were not able to get onto them to collect fares. There were often fatalities due to a lack of resources required for daily life (e.g. heating during winter).

Bosnia and Herzegovina and Croatia, the former federal states, were also affected by hyperinflation during the same period.

Zimbabwe since 2006

Zimbabwe has already had three monetary reforms since 2006. During all of these reforms the same Zimbabwean dollar that had rapidly devalued was returned to circulation.

One of the reasons for hyperinflation in Zimbabwe is continuous printing of money, although trust in the Zimbabwean dollar disappeared a long time ago. At the same time, the country has not made any considerable changes to end inflation and stabilise the economy.

Banknotes with a denomination of 100 trillion (1 and 12 zeros) issued on 16 January 2009 were exchanged for a new currency as early as 2 February that year so that one new banknote equalled a trillion old banknotes. To restrain the inflation, the Minister of Finance at the time decided that the residents of Zimbabwe could use more stable currencies besides the local dollar, and in April 2009 the use of the Zimbabwean dollar as legal tender was terminated for an unspecified period. At present, various currencies (such as US dollars, euros and British pounds) are used in the country.

 Economic models

An economic model is a unique generalisation of reality according to which potential conditions, relations and trends in economic phenomena are evaluated. A macro model describes the operating of an economy at the macroeconomic level via several different equations.

The first macro models are as old as the oldest functioning helicopter, and older than the first ball point pen. The first macro models are considered the works of Jan Tinbergen, a Dutch economist, concerning the economies of the Netherlands and the United States from 1936 and 1939. In 1969 Tinbergen was awarded the first Bank of Sweden Prize in Economic Sciences in memory of Alfred Nobel. As the calculation process of the first macro models was extremely labour-intensive, they could not be used for analyses and forecasts of economic policy, but only to draw conclusions on the basis of single equations. Since the 1940s, extrapolations of the first macro models have been employed to analyse and forecast policy.

Over the years, more and more variables, sectors and additional models have been added to macro models, and thus the macro models have become more voluminous and complicated. The spread of information technology since the 1990s has simplified the compilation of such models and helped to assess them more thoroughly.

Econometrics – a part of economic science developed in the 1930s uniting the possibilities of economic theory, mathematics and statistics – contributes to the preparation of economic models.

 Econometrics

The name ‘econometrics’ originates from the Greek words oikonomia (economy) and metron (measure). Econometrics makes it possible to check economic theory positions, forecast economic indicators and analyse policy by way of models and mathematical and statistical methods. The activities are associated with microeconomics (the study of the behaviour of companies and individuals) and macroeconomics (e.g. forecasting economic growth and unemployment).

As a generalisation it can be said that econometric modelling includes anything from the formation of economic theory positions and development of a model to substantial analysis and use of results. An econometric model includes diverse variables and parameters and, in addition, an accidental component or error term. In other words, with any models it must be considered that in order to grasp reality more effectively generalisations must be made, in the course of which a certain amount of information is lost. Potential errors in source data (or measurement errors) and inaccuracies must also be taken into account when determining the form of a model.

Example of economic model

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1 Lukason, O. (2009). When money burns – fairytale hyperinflation throughout history – Postimees, 07.03.2009 

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