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Definition of Inflation

Inflation describes the steady rise in the price level of an economy. The value of money thus decreases with inflation, and consumers receive fewer goods and services for the same amount. Inflation is, therefore, a continuous process. One-off price increases triggered by unusual events such as strikes or crop failures are not considered inflation.

Inflation rate

In short inflation means an increase in the amount of money in circulation and the associated rise in price levels, while the total quantity of goods in the economy remains the same. In general, inflation is best measured by a price index that reflects the increased price level, such as the consumer price index in Germany. The percentage increase in the price index over a given time frame is called the inflation rate. When the total supply of goods is matched by an inflated money supply, the condition of inflation is fulfilled. If the total supply of goods cannot be increased in the short run, rising prices are the result, and inflation occurs. The price increases can trigger rising wages, which leads to rising costs for businesses. These rising costs, in turn, trigger price increases for goods. Price inflation is again amplified by rising demand. The wage-price spiral begins to spin and accelerate. In such a wage-price spiral, consumers tend to spend their money as quickly as possible before new price increases lead to further losses in purchasing power. There is a concomitant run into material assets.

What does inflation lead to?

Inflation also leads to a devaluation of savings so that the population’s inclination to save decreases. This behaviour restricts the ability of banks to grant loans to companies to finance investments. Consequently, production restrictions and thus higher unemployment can be the result. Groups of people particularly affected by inflation are those who cannot adjust their income to rising prices, such as pensioners and the unemployed. Therefore, fighting inflation is an important goal of any economic and social policy. Thus, price stability is the supporting pillar of functioning markets. It is the prerequisite for the functioning of the price mechanism and, therefore, crucial for economic growth and a high level of employment.
An Introduction to Inflation
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How is the ECB responding to inflation?

The European Central Bank (ECB) once formulated the inflation target as “… below, but close to 2 per cent …”, and recently added in July 2021, “… in the medium term”. However, the ECB does not want this 2 per cent to be understood as an average figure, as the American Federal Reserve understands it. Because that would mean that exceeding the 2 per cent mark would have to be systematically compensated each time. In the end, the ECB only wants to react on permanent and not on temporary deviations in either direction.


However, with the war in Ukraine and the energy crisis, the fight against climate change and the ageing of the population and the associated increasing shortage of skilled workers, so many long-term, strongly price-driving factors have come onto the scene that have forced the ECB to press firmly on the brake pedal and raise the key interest rate to 1.25% (as of September 2022) in two major interest rate steps in the summer of 2022. There is currently a lively discussion about whether the ECB has adjusted its 2022 monetary policy strategy quickly enough to the realities. More than ever, there is a conflict of objectives between strictly designed price level stability on the one hand and combating the energy crisis, climate change and the negative effects of demographic change on the other. One way out is seen in raising the ECB’s inflation target moderately to 3 per cent in future and then communicating this transparently to the public. The ECB will therefore have to manage a very demanding and critical balancing act in the future.

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