Weighted Average

key terms

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monetary policy

price level

A weighted average is the summation of variables, each of which are each multiplied by their relative weight.

The European Central Bank looks at an aggregate level of inflation when it decides what monetary policy action to take.

In order to calculate aggregate inflation a weighted average is used. The ECB multiplies each county’s inflation rate by the relative size (the weight) of each particular country, and then adds all the rates together.

Let’s say the EMU consisted of only Germany, France, and Ireland. Assume these countries had the following level of GDP (used to gauge the size of the country) and inflation rate:

GDP Inflation Rate
Germany 1000 € 1.3%
France 900 € 2.0%
Ireland 100 &euro 6.2%

Notice that the ECB will not notice the high inflation in Ireland because of its small size relative to France and Germany.  See challenges to monetary policy in the EMU

The following graph illustrates this point. The last bar is the aggregate inflation rate for the EMU members (called the Euro Area). It is a weighted average of each of the other countries listed. Notice that the aggregate masks the high inflation rate in Spain and low inflation rate in the Netherlands.
The aggregate of inflation rates: EMU 2007
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