Macroeconomic implications of low inflation in the euro area

Abstract

The ECB’s official inflation objective is an annual increase in the Harmonized Index of Consumer Prices (HICP) 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 in the presence of rigid labor markets in the euro area. Recent experience suggests, however, that concerns about the lower bound are unwarranted, because headline inflation was barely below 2%. 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 increasing economic divergences in the euro area as national inflation differentials translate into national real-interest-rate differentials. We show that aggregate demand in euro-area countries is significantly affected by the euro-area real interest rate, but not by national real-interest-rate differentials.