Macroeconomic implications of low inflation in the euro area

The ECB’s official inflation objective is an increase in the Harmonised Index of Consumer Prices of below 2% in the medium run. Many commentators argue that there is a deflationary bias in this definition because the lower bound of the inflation objective is not clearly specified. It is also often claimed that the ECB’s ambitious inflation objective increases the risk of a liquidity trap and may give rise to higher long-term unemployment because of rigid labour markets in the euro area. An assessment of the experience with the ECB’s inflation objective over the first four years of EMU reveals that the discussion about the lower bound of the ECB’s inflation objective is essentially pointless, because headline inflation was barely below two percent. Fears of a liquidity trap or higher unemployment also appear not to be supported by the empirical evidence. Another popular argument holds that the common monetary policy will lead to an increasing economic divergence in the euro area because of national inflation differentials which translate into national real interest rate differentials. We show that aggregate demand in the euro area countries is significantly affected by the euro area real interest rate, but not by national real interest rate differentials.(This abstract was borrowed from another version of this item.)