Banque centrale du Luxembourg - How does monetary policy affect the economy?

In order to reach its objective, the central bank does not influence prices directly, but through the interest rate. The single monetary policy is thus based on the setting of the short-term interest rate and of the volume of liquidity granted to credit institutions and in consequence to individuals and to the economy as a whole. Actually, changing the interest rate applied to commercial banks, decided by the Governing Council of the ECB, affects the conditions offered to the banks’ own clients. To avoid the risk of inflation (or deflation), one of the tools used by the ECB is the volume of liquidities. Thus, the reduction (increase) of the liquidity provision may discourage (encourage) financial actors to resort to credit which has become more (or less) costly.

The price stability objective is justified, in particular, by the following economic mechanisms:

In an environment of price stability, the market allocates its resources more efficiently. A large degree of price volatility effectively makes the calculation of the future development of prices more uncertain. This uncertainty increases the probability of a non-efficient allocation of resources.
Moreover, long-term interest rates take account of anticpated inflation. If markets anticipate a major degree of inflation, this inflation becomes part of a premium. This premium generates an increase of the long-term interest rates and, all other things being equal, makes investment more costly. Thus, price stability permits an anchoring of anticipations, lowering long-term interest rates, thus promoting growth and employment.
The limitation of monetary erosion encourages the maintenance of the purchasing power of economic agents, promoting consumption, investment and indirectly growth and employment.
Monetary policy, which is directed on the mid-term, smoothes external shocks (shocks on which a specific economic area has no direct control, e.g. oil crisis) and thus contributes to a reduction in the volatility of growth and employment.