Inflation - frequently asked questions (FAQ)

• The European Central Bank can use monetary policy to steer inflation in the euro area through interest rates and through the amount of money circulating in the economy.
• Governments can rein in inflation through the state budgets, by spending less and building up reserves while the economy is growing fast and doing the opposite when it is performing poorly.

It is the task of the European Central Bank to keep inflation in the euro area as a whole at close to 2% over the medium term of 2-3 years. The central bank can affect inflation through its monetary policy decisions.

There are two main ways that monetary policy can affect inflation. The first is by changing interest rates, which set the price of money. The second is by steering the amount of money circulating in the economy, which can if necessary be altered through asset purchases and through lending to commercial banks or depositing their reserves.

If the economy needs cooling, the central bank can increase the price of money by raising interest rates. Another option is to restrict the growth in the amount of money in the economy by making fewer asset purchases, selling financial assets that have already been bought, or limiting lending to the commercial banks. Such measures slow the rate of growth in the economy and so also slow inflation. The opposite can be done if it is necessary to boost the economy, by lowering the price of money and increasing the amount of it in the economy.

It should be noted though with monetary policy that it takes a long time for its full impact to pass into prices, as this is felt only after two or three years. Nor is it possible for monetary policy to affect the prices of individual products. The central bank cannot for example affect the price of oil and other fuels on the global market, as changes in interest rates have no direct impact on the amounts of energy produced and consumed. The most reasonable response of monetary policy to the current very high inflation in the countries of the euro area, which has largely been caused by a fuel price shock, would be to steer expectations that inflation in a couple of years time will still be around 2%. Tightening monetary policy too fast could put too much pressure on the economy at a difficult time.

The monetary policy target of the European Central Bank is to keep average consumer price inflation in the euro area close to 2%. If the state of the economy in a country in the euro area, and consequently its inflation rate, deviates from the average, that difference can be smoothed with national economic policies, especially fiscal or budget policy. Governments can use a well-targeted fiscal policy to smooth sharp changes in the economy, by supporting the economy with additional spending during hard times, and by spending less or building up reserves when the economy is growing fast. The government affects economic activity in the country through how much it takes money in with one hand through taxation and puts it back into the economy with the other hand through state budget spending on civil servants' salaries or road building or other expenses.

If the government spends more money than it receives from taxes and other forms of income, there is a budget deficit and the additional money that is poured into the economy boosts demand and so raises prices. How the money injected into the economy affects inflation depends on the state of the economy at that point in time. Using a budget deficit to revive an economy during a downturn may not cause prices to rise, as some production capacity may otherwise have stood idle without that support. If the economy is doing well though and the private sector is running at full capacity, spending additional money through the state budget can have an inflationary impact. This is because production volumes may prove unable to increase at the same rate that demand does if the existing production capacity is already fully employed. The result is that there are not enough goods on sale to satisfy the demand to buy them, and so prices rise.

• The creation of money had a limited impact, as a large part of the money injected into the economy did not reach people and businesses, but was deposited by the commercial banks back with the central bank.
• The impact on Estonia has been felt through very cheap loans and low interest rates, and indirectly through the support that the European economy received from money printing.

The aim of the asset purchases of the European Central Bank, which has been called money printing, was to revive the economy in the euro area so that it would not fall into a deflationary spiral that would threaten economic growth, jobs, and the ability to repay debts. The goal was to raise inflation, which was tending to remain well below the target of 2%^[1] for the euro area in the past decade. The direct impact of money creation on inflation was limited though because a large part of the money that was added to the economy did not actually reach people and businesses. The activities of the central bank managed to increase the growth in lending, but the commercial banks did not find enough opportunities to lend all this money onwards to their clients. The commercial banks consequently deposited a large part of it back with the central bank.

The impact of the money creation on Estonia has been felt through very cheap loans and low interest rates. Although Eesti Pank was not able to buy many local bonds, the Estonian economy still benefited from the cheap conditions for lending in the euro area. The bond purchases had an indirect impact in Estonia through the prices of imports and probably through stronger demand in the markets for Estonian exports.

• Eesti Pank participates in making monetary policy decisions at the European Central Bank.
• Eesti Pank advises the government by assessing and describing the impact of its policy choices.

Eesti Pank works with the other central banks of the euro area in taking monetary policy decisions, though it must consider the state of the euro area as a whole. Eesti Pank also advises the government of the Republic regularly on important points of economic policy. The central bank helps primarily in assessing and describing the impact on the economy of different policy choices.

Eesti Pank assessed how the monetary policy of the euro area affected the Estonian economy in a thorough review in 2020. The review concluded that overall economic growth in Estonia was around 1 percentage point faster in total in 2017 and 2018 and inflation 0.2-0.3 percentage point higher because of euro area monetary policy than would otherwise have been the case. This review can be read in greater detail on the Eesti Pank website.