The European Central Bank (ECB) is expected to raise interest rates for the first time in 11 years at the end of July. The bank does this, among other things, to combat inflation. But why is this happening? And how does higher interest rates generally lead to lower inflation?
Many European countries are experiencing the highest inflation in recent years. This is also the case in the Netherlands. Last month, life was 11.2% more expensive than a year ago. In other European countries inflation is sometimes even higher. Last month there was an inflation rate of 19.1% in Estonia and 16.6% in Lithuania.
This inflation arose after the corona crisis, when major supply problems arose worldwide. The economic recovery after the quarantine also played a role in many countries. When the war broke out in Ukraine, inflation rose again.
For a long time, the ECB was not in favor of raising the European policy rate. The bank said high inflation had nothing to do with monetary policy in Europe. Only the above factors affect inflation.
That will probably change this summer. The key rate, currently at -0.5%, is likely to be raised to 0% in two stages.
slow down the economy
The central bank does this because higher interest rates affect the amount of money consumers spend. Banks use the policy rate to determine the interest they charge their customers.
A higher interest rate makes it more expensive to borrow money. As a result, people borrow less. Moreover, people with a higher interest rate save more.
Because of these two factors, people spend less money. As a result, the economy slows down.
When the economy slows, aggregate demand for goods and services falls. Prices rise more slowly as demand falls. And as soon as prices rise more slowly, inflation falls. This principle also works the other way around.
A little inflation is good for the economy
The ECB aims to keep inflation at 2%. In order to achieve this, the bank can therefore raise or lower the interest rate.
The bank has chosen this percentage because it believes that some inflation is good for the economy. The gradual rise in prices encourages consumers to spend their money.
Opting for 2% also slows down deflation (the opposite of inflation). If prices fall, inflation does not immediately drop below zero. 2% therefore acts as a safety margin.
Source: NU
John Cameron is a journalist at The Nation View specializing in world news and current events, particularly in international politics and diplomacy. With expertise in international relations, he covers a range of topics including conflicts, politics and economic trends.
