Understanding Inflation and Central Bank Monetary Policy

Posted on Oct 28, 2025 in Economy

Concepts and Causes of Inflation

Concept: Inflation is the widespread and sustained increase in the prices of goods and services in an economy. When inflation or deflation appears, stable prices are lost, generating uncertainty.

Causes: Inflation is typically caused by the behavior of aggregate demand, changes in costs, and defective economic structures.

Types of Inflation

Demand-Pull Inflation

This occurs due to excess aggregate demand over aggregate supply.

  • Monetarist School: Excess demand is produced when the money supply increases above the growth in the production of goods and services.
  • Keynesian School: Accepts that inflation originates from excess demand, but differs in that price increases can be due to non-monetary factors, not just an excess supply of money.

Cost-Push Inflation

This type of inflation is characterized by the rise in costs and prices of raw materials or intermediate products. If a company experiences an increase in costs, even if accompanied by an increase in productivity, it will often move to increase prices to the consumer through rising costs.

Structural Inflation

Structural inflation is a consequence of defective infrastructures, often due to the absence of competition, poor commercial structures, or institutional malfunction. The resulting increase in costs is then translated into higher prices.

The European Central Banking System

European System of Central Banks (ESCB) and ECB

The ESCB is a body formed by the European Central Bank (ECB) and the national central banks of all EU member countries.

Functions of the European Central Bank (ECB)

  1. Regulates the operation of banks.
  2. Authorizes the issuance of banknotes that central banks put into circulation.
  3. Possesses and manages official foreign exchange reserves and conducts operations to maintain the exchange rate.
  4. Defines EU monetary policy.

Functions of the Bank of Spain (BE)

The Bank of Spain does not allow the opening of accounts for the general public but performs several traditional functions:

  1. Serves as the State’s bank for debt issues.
  2. Manages public institutions.
  3. Controls credit and entry of tickets.
  4. Manages the circulation and emission of coins.

Monetary Policy: Tools and Objectives

Definition and Objectives

Monetary Policy is a set of economic and financial decisions pursuing a primary goal: the control of inflation. To achieve this, the central bank acts on the money supply and interest rates through several tools:

Monetary Policy Tools

  1. The Legal Ratio of Cash (Reserve Requirement): This is the percentage of money that banks must maintain in a bank account (in Spain, the Bank of Spain). Increasing or reducing this ratio affects the liquidity of the system. If the ECB increases this ratio, it reduces the amount of money banks have to lend, cooling the economy and reducing aggregate demand.
  2. Open Market Operations (OMO): This involves the central bank buying and selling government bonds and commercial securities to banks. Buying securities provides banks with greater liquidity, which activates the economy due to lower interest rates and potentially a rise in prices.
  3. Credits to the Banking Sector: The granting of credit to banks through the ECB. This increases liquidity in the system, leading to a lowering of interest rates and an increase in aggregate demand.
  4. Interest Rates: The fixed interest rate that serves as a reference for commercial banks.

Types of Monetary Policy

  • Expansionary Policy: Increases the money supply and increases the capacity of banks to grant loans.
  • Contractionary Policy: Decreases the money supply, reducing the capacity of banks to provide loans.