Since 1999 the euro has been in circulation in Germany. But the euro is not only used in Germany; the single currency is legal tender in other European countries, too. In the past, each country's central bank was responsible for its own currency. The central banks of the euro-area countries and the European Central Bank are jointly responsible for the euro. This system of euro-area central banks is called the Eurosystem. Germany’s central bank – the Deutsche Bundesbank – is a member of the Eurosystem.
The primary objective of the Eurosystem is to safeguard price stability. This does not mean individual prices, but the average of all prices: the price level. The price level is calculated using a basket of selected goods and services that are important to our everyday lives. Each month, statisticians work out the prices of the goods in this basket and calculate the average price. This is how we ascertain the price level. The Eurosystem’s objective is to keep the annual increase in the price level at just under 2% in the medium term. If the price level rises significantly for an extended period of time we speak of inflation. If it falls, we speak of deflation.
But why is price stability so important? Price stability helps to preserve the purchasing power of money. Inflation causes money to lose value and reduces its purchasing power. For example, a pair of shoes costs €100 today. If the inflation rate was 5%, you would have to pay €105 for the shoes in one year’s time and almost €128 in 5 years’ time. The higher the rate of inflation, the more sharply prices will rise. When this happens, it is those who receive salaries, pensions or social benefits that are particularly hard hit as, despite inflation, these forms of income generally do not increase at first. This means that people cannot afford to buy as much because prices are rising. High inflation also has disadvantages for savers. Their deposits noticeably lose purchasing power. This affects pensions, for example. In some cases, money that has been saved over many years might no longer be enough to cover living expenses.
But it is not only inflation that damages the economy; deflation does too. Even though people can buy more when prices fall on average, a general decline in the price level also has negative effects. Companies make less profit, and sometimes even a loss. Some even lay off employees as a result. In turn, these workers are not able to afford as much and there is increased downward pressure on prices. On top of this, people postpone purchasing decisions in the hope of prices falling even further. This gives rise to a dangerous downward spiral. Profits and tax revenue decrease; there is a greater burden on public finances as debt rises and spending on social benefits goes up, and less money is invested.
Price stability is also important as it allows companies to plan for the future. This is the only way they can recognise price fluctuations in individual goods, which helps them to accurately gauge supply and demand and organise their manufacturing and investments accordingly.
So what does the Eurosystem do to keep prices stable? The Eurosystem influences the interest rate level in the euro area using monetary policy instruments. If there is a risk of inflation, the Eurosystem will increase interest rates. This results in fewer loans being taken out, less money being circulated and lower demand for goods. Companies might not be able to sell as many of their products, meaning they are unable to raise their prices. Some even lower their prices. In this way, raising interest rates can help fight inflation until prices stabilise again.
If there is a risk of deflation, the Eurosystem will lower interest rates. This results in more loans being taken out, more money being circulated and greater demand for goods. With time, downward pressure on prices eases, allowing companies to raise their prices again. Thus, lowering interest rates can help fight deflation and return prices to a stable level.
Since the introduction of the euro, the inflation rate has averaged under 2%. The monetary policy of the euro system has therefore succeeded in keeping prices stable. Safeguarding price stability will remain the most important task of the Eurosystem in the long run, too, as stable prices are important for a well-functioning market economy, sustainable growth, employment and prosperity. And this is the case everywhere the euro is used as legal tender.