ECB Lowers Interest Rates to Support Growth and Price Stability

Introduction

In June 2025, the European Central Bank (ECB) decided to lower its three key interest rates by 25 basis points, including the deposit facility rate, which now stands at 3.25%. This move came after updated projections showed that inflation was close to the ECB’s 2% medium-term target and expected to remain moderate at 2.0% in 2025, 1.6% in 2026, and 2.0% in 2027. The ECB’s decision was based on an improved inflation outlook, lower energy prices, and a stronger euro. Meanwhile, GDP growth in the euro area is forecast to remain subdued at 0.9% in 2025, gradually rising to 1.3% in 2027 as consumer spending and government investment pick up.

This rate cut represents a classic example of expansionary monetary policy, where the central bank reduces interest rates to encourage borrowing, spending, and investment—supporting economic growth and ensuring inflation remains on target.

Application to IB Economics

This case provides a clear real-world example of monetary policy tools being used to stabilize economic conditions in the euro area.

• Policy Effect on Aggregate Demand (AD): Lowering interest rates reduces the cost of borrowing for households and firms. This encourages higher levels of consumption and investment, shifting AD to the right. The resulting increase in spending supports short-term growth and helps prevent deflation.
• Transmission Mechanism: Through lower policy rates, banks can lend more easily, which improves credit conditions and boosts consumer confidence. A stronger labour market and rising real incomes also help sustain demand.
• HL Concept – Monetary Policy Tools: The ECB sets a benchmark interest rate (the main refinancing rate) to influence borrowing, spending, and investment across the economy. Adjusting these benchmark rates influences money market conditions and overall liquidity in the economy.

In IB Economics Paper 1, this case can be used to illustrate expansionary monetary policy, interest rate adjustments, or macroeconomic management to achieve price stability and growth. It demonstrates how central banks act preemptively to balance inflation control with growth objectives.

Key Terms Explained

• Expansionary Monetary Policy: A central bank policy that increases the money supply or reduces interest rates to boost aggregate demand and stimulate growth.
• Interest Rate: The cost of borrowing or return on saving, used by central banks to influence economic activity.
• Aggregate Demand (AD): Total spending on goods and services at a given price level, composed of C + I + G + (X − M).
• Transmission Mechanism: The process by which changes in policy rates affect borrowing, investment, consumption, and ultimately inflation and output.
• Deposit Facility Rate: The rate banks receive for depositing money overnight with the ECB; it influences short-term market rates.
• Inflation Target: The desired rate of price increase(around 2% for the ECB) to maintain price stability.

This case demonstrates how the ECB uses interest rate cuts to sustain demand and support growth when inflation is stable but economic momentum is weak, highlighting the role of monetary policy in maintaining equilibrium between price stability and economic expansion.