Eurosystem monetary policy is best suited to promoting a favourable economic environment and high employment by ensuring price stability. Without risking price stability, the Eurosystem also supports EU's general economic policy objectives, including a sustainable economic growth, without inflation and maintaining the high competitiveness. Price stability is defined as year-to-year increases in the Harmonised Index of Consumer Prices (inflation) for the euro area of below 2%, and price stability is to be maintained over the medium term. The rate of inflation must be close to 2%. Thus, a harmful spiral downward spiral of prices can be avoided. The inflation target also takes into account potential measurement errors. Inflation and deflation are important economic phenomena that have negative effects on the economy. In general, inflation is defined as a general increase in the prices of goods and services that will result in a decrease in the value of money, that is, a decline in purchase power. Deflation is often defined as the opposite to inflation, in other words a situation where the general price level continuously falls. Price stability refers to conditions where there are no real signs of inflation or deflation, where prices do not fall or rise notably but remain stable over time. Inflation is harmful in many ways. It undermines economic decisions and leads to slower economic growth. In addition, inflation is unfair, since it eats up the value of savings and weakens the position of small savers in particular. Deflation is even more harmful than inflation. It results in a downward spiral of prices and wages while the value of money goes up. During periods of deflation, repayment of loans must be made with money that is worth more than when the loan was taken, and hence deflation has often given rise to debt crises and a growth in bankruptcies. The Eurosystem, made up of the euro area central banks, is responsible for maintaining price stability in the euro area. The Eurosystem conducts monetary policy in order to safeguard price stability in the euro area. Monetary policy is often perceived as merely setting the short-term interest rate. In a broad sense, however, monetary policy comprises the impact of all government measures on the structure and functioning of the financial system. In practice, monetary policy is carried out by the national central banks (NBCs) in the euro area. The NCBs regulate amounts of currency in circulation, market rates and foreign exchange rates. The price stability objective means that inflation and inflation expectations must be kept under control. The most efficient way for a central bank to dampen expectations is to set a measurable target and clear strategy for monetary policy, thus informing the general public beforehand which economic indicators the central bank focuses on and how it plans to achieve its objectives.
Monetary policy is transmitted to the economy in many different ways. Monetary policy operations affect the liquidity of the banking system and the shortest money market rates. Price formation in the financial markets is reflected in banks' lending and deposit rates and in long-term market rates. In addition, monetary policy has an indirect effect on asset prices, monetary aggregates and lending volumes, inflation expectations, inflation and other macroeconomic developments.