Shutterstock / tichr
Shutterstock / tichr


Since the collapse of Lehman Brothers in September 2008, the central banks of most industrialized nations have been running an expansionary monetary policy. Even so, the European Central Bank (ECB) has not achieved its target inflation rate of two percent for some years. This blog post examines why the massive increase in the money supply engineered by the ECB has not succeeded in producing the desired increase in inflation.


What is the central banks’ objective?


The ECB’s official monetary policy sets a medium-term inflation rate of close to but below two percent (page 64). This moderate rate of inflation is intended as a buffer to ward off a damaging slide into deflation. However, inflation in itself is not a particularly desirable target: inflation means that the value of a given quantity of money decreases as time passes. Money in your saving account loses value. Workers can expect a reduction in the purchasing power of their wages.


Actually, the economic policy objective of an expansionary monetary policy is to increase economic growth and employment. In this context, an increase in the overall level of prices merely presents an intermediate objective, since increasing prices can be an indicator of economic growth:


  • In a market economy, prices increase when the overall demand for goods increases faster than the overall supply. In this case, increasing prices signal increasing scarcity.
  • Companies react to scarcity signaled in this way by increasing the supply of goods. This leads to an increase in production volumes, which is normally accompanied by higher employment.
  • This results in an increase in gross domestic product (GDP) across the whole economy and in employment, thus leading to economic growth.


The inflationary process described here leads, by way of greater demand for goods, to increased production of goods by companies and therefore to increased growth. Consequently, demand-induced inflation of this kind promotes growth.


Increases caused by a straightforward increase in production costs are a different matter. If the production costs for companies increase – for example, because the price of oil rises or because reintroducing border controls increases transport costs – this usually also leads to higher goods prices. This price increase reduces consumer spending power, thus reducing consumer demand. A drop in consumer demand leads companies to adjust to the lower demand for goods, meaning they reduce production and therefore employment. This form of inflation – referred to as supply side inflation – has a negative impact on growth and is therefore not a desirable type of inflation.


How can an expansionary monetary policy speed up economic growth?


The central bank’s aim when increasing the money supply is to increase macroeconomic demand for goods and so stimulate growth. An increased money supply and the associated cut in interest rates are able to boost macroeconomic demand via three main transmission channels:


  1. Cuts in interest rates increase business investment. When interest rates go down, investment projects that would not be profitable if interest rates were higher become attractive to companies. This means there is an increase in demand for capital goods, i.e. primarily machines, production plants, and the buildings these require.
  2. Lower interest rates increase credit-financed consumer consumption. This especially affects demand for consumer durables and property.
  3. Low interest rates lead to a devaluation of the local currency, which in turn increases the country’s exports. When eurozone interest rates are cut, this reduces Europe’s attractiveness to foreign investors as a place to invest their money. This then reduces the demand for euros. As a consequence, the price of the euro drops, meaning that the currency is depreciates. This makes European products cheaper in the rest of the world, so eurozone exports rise.


Higher investment, exports, and consumer spending result in increasing production and higher employment. If more people have jobs, the income available within the economy increases. This increases consumer demand. At the same time, increasing production requires an increase in production capacity, leading to greater investment demand (see Figure 1). As a result, increasing the money supply leads to an increase in production and employment and thus to higher economic growth. Prices increase if the demand for goods outstrips the supply.



Figure 1: Growth-boosting effects of an expansionary monetary policy; author’s own diagram


Growth and inflation in Europe


A glance at the growth rates for real GDP in selected global regions shows that economic growth in the eurozone has still not recovered from the slump following the Lehman collapse. With a growth of 1.5 percent, the growth of real GDP in the eurozone for 2015 was only half that of the growth in global GDP (see Figure 2).



Figure 2: Annual rate of change in gross domestic product (constant prices) in selected country groups; data in percent. Source: World Economic Outlook Database (October 2015)


Weak GDP growth is primarily due to too slow an increase in macroeconomic demand. In turn, this weak demand means that goods prices in Europe do not increase – and the current inflation rate is not only falling far short of the two percent target, but is hovering on the brink of deflation and has occasionally crossed this line more than once (see Figure 3).


Weak GDP growth is primarily due to too slow an increase in macroeconomic demand. In turn, this weak demand means that goods prices in Europe do not increase – and the current inflation rate is not only falling far short of the two percent target, but is hovering on the brink of deflation and has occasionally crossed this line more than once (see Figure 3).



Figure 3: Annual inflation rates in Europe; data in percent. Source: Eurostat


Why isn’t the expansionary monetary policy in Europe leading to higher inflation?


If a massive increase in the money supply does not lead to higher inflation, this is because growth in demand is not strong enough despite that increase. Demand is failing to grow, particularly in terms of consumer demand and business investment.


There are four underlying reasons for the lack of a credit-based increase in consumer demand.


  1. High-income and asset-rich consumers have a good income. They are already saving part of their available income and so they do not need additional credit to finance their consumption.
  2. Low-income consumers who have few assets would like to consume more, but they are often not granted loans because they do not have the necessary collateral. Consequently, these consumers also do not contribute to any appreciable credit-financed increase in consumer demand.
  3. Furthermore, it has to be taken into account that low interest rates have now been in place for several years. Therefore, it can be expected that those who would be granted consumer credit have already received such credit during recent years and no longer need any further loans.
  4. Finally, expectations about how inflation will move in the future play an important role. If inflation is expected to rise, people will anticipate this rise in prices and set contracts and prices accordingly, thus creating a dynamic that itself creates inflation. By contrast, if low or even decreasing prices are expected for long periods, then a deflationary spiral can develop. It is the second scenario in particular which the central banks presently fear.


Given the lack of growth in consumer demand, there is hardly any incentive for companies to increase their production capacities. Uncertainty over further developments on European integration (i.e. Grexit, Brexit, and the reintroduction of border controls within Europe) is also a reason for reticent investment activity. Another reason is the long-term effects of the financial crisis on the banking sector. Non-performing loans (NPLs), i.e. loans for which interest payments are not made, increased sharply as a share of the credit issued by banks between 2007 and 2013, and have only decreased slightly since then. Given that the banks have to set aside reserves to cover the risk of default, the liquidity that has been provided by the central bank is often used to build up reserves, instead of to issue loans. Low lending leads to lower investment and consumption. As a result, the objective of an expansionary monetary policy – to increase investment demand – is not achieved.


With that said, low interest rates in the eurozone have led the euro to devalue and have therefore improved export opportunities for European companies. However, at present, it can also be observed that economic growth in many emerging countries is slowing – especially in China. Against the Chinese renminbi or the Indian rupee, the euro has actually gained in value, while against the US dollar and pound sterling it has depreciated. This is making it increasingly difficult to find buyers for European goods abroad, despite the devaluation of the euro. Consequently, there is also a risk that the demand-boosting effects of exports will begin to drop off. There are also grounds for concern that, sooner or later, other central banks will also begin to increase their money supplies, in order to devalue their currencies and improve export opportunities for their domestic companies. This brings with it the threat of a global currency war.


Of the three transmission channels (see Figure 1) via which an expansionary monetary policy can be effective – consumption growth, export promotion, and facilitation of lending – the only one showing a positive effect is export promotion through currency devaluation. For the reasons given above, there has been no appreciable increase in consumption and the banks are not lending as much as expected. However, the latest Bank Lending Survey from the ECB indicates that banks have become more generous when lending, which could mean that the bank transmission mechanism is now working more effectively.


In conclusion, the following can be said of the eurozone: even a massive reduction in interest rates as a result of the increased money supply over recent years has not led to the desired inflation rate of two percent, because macroeconomic demand is too low to enable this to happen. The money being made available by the ECB is not reaching the product markets; instead, it is flowing into the asset markets (shares, bonds etc.) and causing prices to rise on those markets, potentially leading to speculative bubbles.


Is quantitative easing a solution?


Similarly to most of the central banks of other industrialized nations, the ECB has reacted to the lack of success evident from following its conventional monetary policy. One conventional instrument of expansionary monetary policy is to cut the base interest rate. However, since this approach is losing its effectiveness and the ECB’s base interest rate has been at or below 0.5 percent since May 2013, ECB Governor Draghi announced the start of quantitative easing on January 22, 2015. Under this monetary policy instrument, the central bank buys government and corporate bonds from private banks and large investors on the secondary market. This enables the ECB to pump money into the economy. Since March, the ECB has bought government bonds worth 60 billion euros every month; from April, purchase volumes were increased to 80 billion euros.


This bond-buying program has been running for over a year and, evidently, it has not led to any appreciable increase in the inflation rate. In our opinion, this is due to the continuing lack of growth in consumer and investment demand. As has been explained above, merely providing greater liquidity is hardly going to be able to generate the required boost in demand. In order to achieve this, accompanying measures are necessary to redistribute available income or purchasing power to low-income households or to the state. In the case of low-income households, it can be expected that their consumption would increase. The state will be able to increase expenditure on investment for the future (education, training, infrastructure etc.) and thus stimulate macroeconomic demand. In this situation, it would then also be worthwhile for companies to invest.


Details of how this transfer of purchasing power is to take place, and especially the advantages and disadvantages of various specific measures, need to be discussed. However, unless a fundamental economic policy decision of this kind is made, it will be very difficult to boost economic growth in Europe.


Note for the reader: If you are interested in more information about the instrument of quantitative easing, the Bank of England offers this information in a short paper entitled “Quantitative easing explained”.