How does a country control inflation

Economics I


1. Money supply

moneythat is not yet in the economic cycle - more precisely: that does not yet exist - becomes, like other goods, offered and asked. When the supply of money and the demand for money meet, money is created that "Money creation".

Economic agents can always then extra money come when you transferring assets to a bank and get money for it. For example, a bank sells securities to the central bank and receives banknotes in return. The assets transferred to a bank can also be of an intangible nature, such as receivables: For example, a consumer receives book money (giro money) credited to an account on the basis of a loan and the bank receives a receivable from the borrower in return. Will the concerned Transferring the asset back, e.g. the securities from the central bank to the bank or the claim from the bank to the consumer, because the credit expires, it comes to "Money destruction", namely banknotes or book money (deposit money).

There are three sources of money creation:

  • the Central bank, the Central bank money (Banknotes, coins and bank deposits at the central bank),

  • the Commercial banks, the Book money (= Deposit money) can create,

  • the foreign countries, from which, for example, by paying for exports or through loans Euro amounts, currency (liquid claims on foreigners) or Foreign currency (foreign cash), enter the domestic market.

The central bank in the case of the euro zone is the European Central Bank (ECB) in Frankfurt, which acts on behalf of the European System of Central Banks (ESCB).

The central bank often delegates the production of coins to the state, but authorizes the quantities to be produced. In Austria, the coins are produced by Münze Österreich AG, a subsidiary of the Oesterreichische Nationalbank. Münze Österreich AG sells the coins at face value - i.e. well above the production costs - to the Oesterreichische Nationalbank and credits the coin profit to the state. The Oesterreichische Nationalbank puts the coins into circulation.

The creation of money also creates the legal character of money clear: it is a Advancement to the institution that creates the money, i.e. one creditthat the recipient of the money grants to the money-creating institution. Both the central bank and the commercial banks pay with when they provide money Demands on yourself. Foreign economic entities pay with claims to their country's central bank or to a commercial bank in their country.


By paying with demands on yourself is subject to the creation of money by the respective money-creating institution too no limit, unless artificially - e.g. by laws - such Boundaries built become. From the outset there are limits to the availability of money (a "Liquidity problem") Only those who have the money that they use can not create himself (e.g. the bank with regard to central bank money or the "non-bank" - e.g. an industrial company or a consumer - with regard to central bank money and book money).

The The central bank actively creates and destroys central bank money, i.e. it is encouraged by an attractive Terms and conditions the banks and other economic entities to sell their assets (e.g. securities) or also to pledge them with them or take out a loan from them (money creation) or to buy assets from them (e.g. in turn securities) or to repay a loan from them (money destruction) . They play a special role in determining the terms and conditions of the central bank interestto which it lends money or, in the case of deposits from other economic entities, especially the "Base rates", i.e. in the case of the European Central Bank the interest at which it provides the banks with short-term money.

aim of the aforementioned activities of the central bank - the "Monetary policy" - is it the Sufficient money supply for the economy, but still so close that Avoided inflation will ensure.

To the Money creation by banks the central bank requires that a certain percentage of a bank's liabilities be held as credit with the national bank. These credits are known as Minimum reserves or the percentage that must be kept as credit as Reserve ratio. For different types of liabilities (e.g. current accounts, savings accounts) different levels of minimum reserves must be held. By changing the minimum reserve rates, the central bank can control the banks' money creation. The minimum reserves are part of that Safety reservesthat the banks hold in order to have enough money available for cash withdrawals by customers.


2. Multiple deposit money creation

The banks work together in the creation of book money (deposit money). One therefore speaks of a "multiple deposit money creation process":

The multiple deposit money creation process

For example, if "Customer 1" deposits 1,000 euros in cash at "Bank 1" and the minimum reserve ratio for this bank liability is 10%, the bank will credit the depositor with 1,000 euros to his current account, but it must add an additional 100 euros to the central bank Insert minimum reserve. Bank 1 then has an additional "free reserve" of 900 euros, in the amount of which it can grant another customer ("customer 2") a loan.

Customer 2 transfers the 900 euros credited to him to another bank ("Bank 2"), where the transferred money is deposited as book money in the checking account of customer 2. Bank 2 must also deposit 10% of this, i.e. 90 euros, as a minimum reserve with the central bank, so that it has an additional free reserve of 810 euros. Bank 2 can grant customer 3 a loan in this amount.

Customer 3 places the 810 euros in his current account at bank 3. Bank 3 has to deposit a minimum reserve of 81 euros and thus has a free reserve of 729 euros. It can grant a loan to customer 4 in this amount.

This multiple money creation process continues until the entire original cash deposit of EUR 1,000 has been deposited by the participating banks as a minimum reserve at the central bank, i.e. deposit money totaling EUR 10,000 has been created.

The multiple gel creation process is restricted, however, if customers withdraw cash from their banks and this cash is not deposited at a bank (then correspondingly less book money flows from one bank to another, so that the banks' free reserve for bank money creation is lower) and if they are involved Banks voluntarily increase their reserve holdings.


The Central bank required in order to be able to carry out monetary policy seriously, numerous economic data. These data include in particular - in addition to data on economic growth and inflation - data on the Money supply (the Money supply). The amount of money (volume of money) is understood to be the amount of money available on a specific reference date in the non-bank sector (= in private and public households and in companies that are not banks). Most of the time the "Monetary aggregates" M1, M2 and M3 differentiated. In order to obtain the next largest monetary aggregate, less and less liquid types of money are gradually added. The following graphic contains the European Central Bank Definitions for the individual monetary aggregates:

Repurchase agreements (Repo transactions, repos) consist in the short-term takeover of securities from commercial banks by the central bank with a repurchase agreement, from which the German term "repo" comes. These transactions are used to raise funds for the commercial banks in the short term.
Money market fund shares are units in funds that invest in money market paper.
Money market papers are short-term securities.
Bonds (Bonds) are debt obligations that are securitized as securities, usually with a fixed interest rate and a fixed term.


3. Demand for money

The Demand for money of economic agents is mainly based on the need for money To do business (whereby a certain security requirement must be taken into account as a precaution), and the money required to speculate to be able to, i.e. to have money in reserve in order to primarily buy securities when a favorable opportunity arises.

The money held for the first reason is called "Transaction checkout"that held for the second reason"Speculative fund"; they do both together Demand for money in an economy.

The following Graphics shows schematically how the Transaction checkout in the course of the month developed: households have a lot of transaction funds at the beginning of each month and have largely used it up by the end of the month, companies have little transaction funds at the beginning of the month and a lot of transaction funds at the end of the month. The Sum of the average transaction balance of households and companies results in the Transaction Fund of the National Economy and thus the one corresponding to the respective economic situation Demand for transaction register.

Graphics based on: Gabriele Hildmann, Macroeconomics Intensive Training, Gabler, Wiesbaden 1997, page 98
GE = monetary units

The Transaction checkout requirement (LT) depends on the economic situation and thus on the Level of national income (Y) determined, but taking into account the Speed ​​of rotation of money (u). The higher the speed of circulation of money, the less transaction cash you can get with the same national income. It therefore arises following relationship:


The Supply with transaction register is then sufficientif with the existing Money supply (M) that real national income (Yr), multiplied by one Coefficients for the price level (P) can be bought with it. The following equation, the Quantity equation of money, expresses this:

The high of Transaction checkout can, however also from other factors than the national income and the speed of circulation of money. This includes the interest and an eventual high inflation.

If the Interest rates rise, holding cash is becoming increasingly uneconomical because assets other than cash are increasingly generating better returns. When interest rates rise, economic agents are trying to get by with less cash than before. In this case, the speed of circulation of money increases, i.e. people hold less money, but go to the bank more often to get new cash. This is symbolized with the expression "shoe leather costs"(What is meant is that the soles of shoes wear out more from going to the bank and they have to be replaced more often). When interest rates rise, companies try to get their"Cash management"in order to get by with even smaller cash holdings.

High inflation rates also induce economic agents to hold less cash, but rather to flee into tangible assets or more stable currencies. That too is with costs that arise, for example, through the search for suitable material assets, through contracts and taxes for the purchase of material assets.

The Speculative fund depends on the amount of interestthat can be expected from the purchase of securities in the future. Fixed income securities have one Face value, a current one Market value and one Nominal interest. The amount paid annually as interest corresponds to the nominal interest calculated from the nominal value. If, for example, the interest level in the economy falls below the nominal interest rate of a security, the economic subjects will want this security because they can earn higher interest rates than the general interest rate with it. However, as a result of the higher demand, the market value of the security will rise until the Effective interest rate of the security (nominal value x nominal interest / market value) corresponds to the interest rate level of the economy and therefore there is no longer any incentive to buy the security.

If you want to achieve the highest possible profit from the higher effective interest rate and the increase in the market value of a security in the future, that's it It is reasonable to buy the security while the interest rate level in the economy is high and the price of the security is low. One speculates on a falling interest rate, a temporarily higher effective interest rate than the interest rate and thus on a rising market value.

Generally one can thus say that the speculating economic agents with one high interest rates reasonably less speculative money than will hold at low interest rates because they spend their speculative money on buying securities when interest rates are high.

A total of it is important for monetary policy that Money supply (the money supply) the Demand for money (Transaction box + speculation box) as good as possible adaptin order to avoid inflation, but to meet the needs of economic agents for holding money, e.g. for more transaction cash in the event of increasing economic growth.


4. Inflation and Deflation

Under inflation one understands Increase in the price levelthat is not only due to seasonal price fluctuations (e.g. for agricultural products).

In addition to seasonal price fluctuations, it also happens that the prices of the goods offered in an economy change in relation to one another. Such a change in the price structure (the "relative prices") is not considered to be inflation as long as price increases and price decreases balance each other out on balance. Inflation occurs only when the price increases exceed the price decreases.

A meeting of inflation and stagnation in economic growth is known as stagflation.

There are different Types of inflation. According to the height you can get a moderate inflation (a few percent), one galloping inflation (two- to three-digit inflation rates) and one Hyperinflation (from four-digit inflation rates upwards).

A Demand inflation arises when demand - made possible by a corresponding growth in the money supply - grows faster than production capacity. A Supply inflation arises when there are cost surges, e.g. due to external price shocks (e.g. for oil) or wage increases that exceed the previous inflation rate plus the percentage of the productivity increase.

Inflation caused by higher prices of imported goods is one imported inflation. Fixed exchange rates are usually required for imported inflation, as only if the foreign currency is not devalued due to inflation in the country in question, the inflation can be fully transferred to the country of the trading partner.

For economic policy the distinction is in expected inflation and unexpected inflation significant. Economic agents adjust to expected inflation, i.e. - almost as a habit - year after year, prices and wages are increased to the extent of the expected inflation. This type of inflation is also called "creeping inflation"or"core inflation".


Inflation is expressed as a percentage of the increase in price levels over a given period (e.g. one year). So you get the inflation rate. The price level is indicated with an index.

The Measuring inflation is done with a Price index. One determines a group of goods that remains the same for a longer period of time (the "shopping cart") mostly monthly prices and weights these prices according to the importance of the goods concerned for the group of economic subjects for whom inflation is measured (e.g. for consumers at"Consumer price index"or the wholesalers and their customers, the retailers, at"Wholesale price index"). One of the average annual price levels is then set equal to 100 and all subsequent price levels are compared in percent with this base level. The percentage increase from one price level to another gives the inflation rate.

The Consumer price index exaggerates usually inflation. This is due to the fact that he Quality improvements of the individual consumer goods (e.g.the more stable behavior of Windows XP compared to Windows 2000) and the frequent Dodging consumers on cheaper products in the event of price increases for certain products, as long as the entire shopping basket is not revised (which usually - as in the EU - happens every five or otherwise every ten years). If one overestimates inflation, deflating the nominal gross domestic product results in a real gross domestic product that is too low or real growth rates too low.

One can also calculate a price index for the entire gross domestic product, which changes annually in its composition. The shopping basket is, so to speak, the entire economic output. This price index is known as Gross domestic product deflator (GDP deflator). If you want that from the nominal (expressed in money without inflation adjustment) gross domestic product real (= adjusted for inflation) Gross domestic product calculate, one divides the nominal gross domestic product by the deflator of the gross domestic product.


A constant creeping inflationthat is expected by the economic agents and is therefore built into their planning (e.g. pricing and wage structures) no particularly harmful effects. However, progressive income taxation (such as income tax) steers away ever larger parts of the income ("cold progression"), so that if inflation persists, at least from time to time a Adjustment of tax rates downwards necessary is.

It is different with a unexpected inflation: It is not taken into account in the planning of economic agents, i.e. it surprises them and, above all, it leads to the following harmful effects:

  • The Prices, the most important Planning basics for entrepreneurs and consumers, are affected by the change in relative prices associated with every inflation distortedso that bad planning occurs.

  • It comes to Shifts in the asset structuremainly because debtors win over creditors.

  • Kick it Adjustment costs on, namely the costs for a possible diversion into assets, but also "menu costs", i.e. costs for the entrepreneur, e.g. for frequently changing price catalogs.

  • The Fighting inflation through economic policy requires strong Economic slowdown, mostly with higher unemployment and with Bankruptcies connected is.

Considering this cost, it is reasonable to have inflation in time, so before it fully settles, close fighteven if the risk of a slowdown in the economy has to be accepted.

Possibilities, protect against inflation, are, in addition to the flight into material assets, e.g. for the obligee the agreement floating rate (such as floating rate bonds), one balanced structure of receivables and liabilities in the balance sheet or the Indexing, i.e. the linkage of payments (e.g. pensions, rents, loan repayments and interest) to an index, e.g. the Harmonized Index of Consumer Prices (HICP).

How much about the nominal (= not adjusted for inflation) and the real (= adjusted for inflation) interest the following considerations show:

The opposite of inflation, a sustained fall in the price level, is what is called deflation. Deflation mostly occurs in an economic crisis caused by the "Bursting bubbles"(" bubbles "), i.e. the sudden correction of significant overvaluations on the stock markets (" financial bubbles ") or on the real estate markets (" real estate bubbles ").

Deflation leads to "Attentism", i.e. a wait on the part of buyers, both consumers and entrepreneurs, due to the expectation of further reductions in prices. As a result, demand continues to decline, creating a" deflationary spiral ".

The central bank can use the instrument of deflation Interest rate policy, i.e. in the specific case by lowering interest rates, only fight them as long as interest rates are not already (almost) zero. If no further rate cuts are possible, the central bank can try to reduce the interest rate Money supply to increase (e.g. through the purchase of securities) or the state tries to through Infrastructure investments or through Subsidies to stimulate the economy - if the budget can handle it.

The Risk of deflation is due to interest rate cuts relatively easy to fight (as long as the economic climate is not too negative). One that has already occurred persistent deflation is for the reasons mentioned in the previous paragraph difficult to fight.

Inflation or deflation and interest rates

Let's assume someone has an amount of 100 euros and can use it to buy a certain shopping cart. He now lends this 100 euros for 1 year at a nominal interest rate of 6%. This year, the price of his basket of goods, as well as the overall price level, and thus the consumer price index, rose from 110 to 112. This corresponds to an inflation rate of (rounded) 1.8%. After one year, the person in question will get their money back plus 6% interest, i.e. 106 euros.

How much of their original shopping cart can the person in question buy with 106 euros? Obviously 1.0411 times this shopping cart:

This means that the real interest rate in this case is (rounded) 4.11%.

In general, if you compare the nominal interest rate with in (in our example: i = 0.06), the real interest rate with ir and the two index sizes with P0 and P1 designated:

Cash has a nominal interest rate of 0. The inflation rate given above by the two indices results - as expected - in a loss of purchasing power for cash of (rounded) 1.8% (1 - 0.982):

From these calculations it can be seen that the real interest rate can also be calculated with sufficient accuracy as follows (where R is the real interest rate, N is the nominal rate of interest, in our example 6%, and I is the inflation rate, in our example 1.8%, is):

This results in an approximate real interest rate of 6 - 1.8 = 4.2% for the above loan with a nominal interest rate of 6%.

If income tax were also taken into account in this calculation, the real after-tax interest rate would be significantly lower. If one assumes, for example, that the interest rate has already risen to 7.8% (6% + 1.8%) due to the expected inflation and that the marginal tax rate is 40%, then from 7.8% interest income 3.12% is steered away so that 4.68% interest remains after income taxation. However, the loss of purchasing power due to inflation of 1.8% must be deducted from this, so that real interest remains after taxation of 2.88%.

In the case of deflation, the calculation is carried out the other way around, i.e. if the price level drops by 10%, for example, dividing or simplified by 0.9, but only approximately, the deflation rate is added to the nominal interest rate.


Web design, content, copyright: Dr. Klaus Zerbs, Linz 2002