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The role of money and monetary policy of the central bank in pursuing macroeconomic stability has significantly changed over the period since the end of World War II. Globalization, liberalization, integration, and transition processes generally shaped the crucial milestones of the macroeconomic development and substantial features of economic policy and its framework in Europe. Policy-driven changes together with variety of exogenous shocks significantly affected the key features of macroeconomic environment on the European continent that fashioned the framework and design of monetary policies.

This chapter examines the key basis of the central bank’s monetary policy on its way to pursue and preserve the internal and external stability of the purchasing power of money. Substantial elements of the monetary policy like objectives and strategies are not only generally introduced but also critically discussed according to their accuracy, suitability, and reliability in the changing macroeconomic conditions. Brief overview of the Eurozone common monetary policy milestones and the past Eastern bloc countries’ experience with a variety of exchange rate regimes provides interesting empirical evidence on origins and implications of vital changes in the monetary policy conduction in Europe and the Eurozone.

Empirical studies on household-level inflation inequality have so far only focused on periods with positive inflation rates. However, the major concern on the policy agenda since the most recent financial crisis has been deflation rather than inflation. This naturally raises the question regarding the effect of deflation on the distribution of real income when households spend their budget on different consumption bundles. This chapter compiles annual household-level inflation rates in Denmark from 1930 to 1935 based on microdata from the Expenditure and Saving Survey of 1931 and price data from the official Retail Price Index. The results indicate that lower-income households faced a larger decline in prices on their consumption of goods and services during the deflation years 1930–1932 than higher-income households did. The deflation thus contributed to narrowing the difference in real incomes between the top and bottom parts of the income distribution during the recession. In the years 1933–1935 with positive inflation rates, the lower-income households experienced higher inflation rates than higher-income households. Over the period 1930–1935 seen as a whole, the price development contributed slightly to reducing real income inequality. The low degree of medium-term persistence of differences in household-specific inflation rates is consistent with previous findings in various time periods from the 1960s to the 2000s without any persistent deflation events. The chapter at hand is the first empirical study of the direct distributional effects of price developments at the household level in a period with persistent deflation.

In this chapter, we define the “inflation forward rates” based on arbitrage arguments and develop a dynamic model for the term structure of inflation forward rates. This new model can serve as a framework for specific no-arbitrage models, including the popular practitioners’ market model and all models based on “foreign currency analogy.” With our rebuilt market model, we can price inflation caplets, floorlets, and swaptions with the Black formula for displaced-diffusion processes, and thus can quote these derivatives using “implied Black's volatilities.” The rebuilt market model also serves as a proper platform for developing models to manage volatility smile risks.

Through this chapter, we hope to correct two major flaws in existing models or with the current practices. First, a consumer price index has no volatility, so models based on the diffusion of the index are essentially wrong. Second, the differentiation of models based on zero-coupon inflation-indexed swaps and models based on year-on-year inflation-indexed swaps is unnecessary, and the use of “convexity adjustment,” a common practice to bridge models that are based on the two kinds of swaps, is redundant.

Long-term interest rates of small open economies (SOE) correlate strongly with the USA long-term rate. Can central banks in those countries decouple from the United States? An estimated Dynamic Stochastic General Equilibrium (DSGE) model for the UK (vis-á-vis the USA) establishes three structural empirical results: (1) Comovement arises due to nominal fluctuations, not through real rates or term premia; (2) the cause of comovement is the central bank of the SOE accommodating foreign inflation trends, rather than systematically curbing them; and (3) SOE may find themselves much more affected by changes in USA inflation trends than the United States itself. All three results are shown to be intuitive and backed by off-model evidence.

The new economic-policy regime in Sweden in the 1990s included deregulation, central-bank independence, inflation targets and fiscal rules but also active labour market policy and voluntary incomes policy. This chapter describes the content, determinants and performance of the new economic policy in Sweden in a comparative, mainly Nordic, perspective. The new economic-policy regime is explained by the deep recession and budget crisis in the early 1990s, new economic ideas and the power of economic experts. In the 1998–2007 period, Sweden displayed relatively low inflation and high productivity growth, but unemployment was high, especially by national standards. The restrictive monetary policy was responsible for the low inflation, and the dynamic (ICT) sector was decisive for the productivity miracle. Furthermore, productivity increases in the ICT sector largely explains why the Central Bank undershot its inflation target in the late 1990s and early 2000s. The new economic-policy regime in Sweden performed well during the global financial crisis. However, as in other OECD countries, the moderate increase in unemployment was largely attributed to labour hoarding. And the rapid recovery of the Baltic countries made it possible for Sweden to avoid a bank crisis.

This article describes an experiment in a Kydland/Prescott type of environment with cheap talk. Individual evolutionary learning (IEL) acts as a policy maker that makes inflation announcements and decides on actual inflation rates. IEL evolves a set of strategies based on the evaluation of their counterfactual payoffs measured in terms of disutility of inflation and unemployment. Two types of private agents make inflation forecasts. Type 1 agents are automated and they set their forecast equal to the announced inflation rate. Type 2 agents are human subjects who submit their inflation forecast and are rewarded based on their forecast error. The fraction of each type evolves over time based on their performance. Experimental economies result in outcomes that are better than the Nash equilibrium. This article is the first to use an automated policy maker that changes and adapts its rules over time in response to the environment in which human subjects make choices.

By reducing the real value of nominally fixed tax band limits, deductions and tax credits, inflation can lead to higher real tax burdens (“fiscal drag”). The traditional view is that this reduces aggregate demand and thus acts as an automatic stabiliser. Yet, this familiar reasoning ignores the supply side and, in particular, possible effects of higher tax burdens on labour costs. Recent work on imperfect labour markets has shown that such effects can indeed arise as employees are able to bargain for higher wages that partly compensate for tax increases. In this case, the resulting upwards pressure on real labour costs can be inflationary. To illustrate this mechanism, this article analyses labour tax burdens in four European countries and how they are altered if tax systems are not adjusted for inflation. This is then combined with available results on the effects of tax changes on wages in imperfect labour markets. The results suggest that, in an unadjusted tax system, inflation can produce a moderate upward pressure on wages. It is argued, however, that more detailed empirical work on the role of taxes in the wage-setting process is needed as existing work ignores the substantial heterogeneity of workers and the tax rates they face.

This chapter analyzes the exchange rate pass-through (ERPT) into different prices for 12 euro area (EA) countries. We provide new up-to-date estimates of ERPT by paying attention to either the time-series properties of data and variables endogeneity. Using VECM framework, we examine the pass-through at different stages along the distribution chain, that is, import prices, producer prices, and consumer prices. When carrying out impulse response functions analysis, we find a higher pass-through to import prices with a complete pass-through (after one year) detected for roughly half of EA countries. These estimates are relatively large compared to single-equation literature. We denote that the magnitude of the pass-through of exchange rate shocks declines along the distribution chain of pricing, with the modest effect recorded for consumer prices. When assessing for the determinant of cross-country differences in the ERPT, we find that inflation level, inflation volatility, and exchange rate persistence are the main macroeconomic factors influencing the pass-through almost along the pricing chain. Thereafter, we have tested for the decline of the response of consumer prices across EA countries. According to multivariate time-series Chow test, the stability of ERPT coefficients was rejected, and the impulse responses of consumer prices over 1990–2010 provide an evidence of general decline in rates of pass-through in most of the EA countries. Finally, using the historical decompositions, our results reveal that external factors, that is, exchange rate and import prices shocks, have had important inflationary impacts on inflation since 1999 compared to the pre-EMU period.