Final answer:
The ECB uses monetary policy to maintain price stability by targeting a low inflation rate, which in turn minimizes exchange rate fluctuations and promotes competition. Though monetary policy has limitations due to unpredictable factors, it aims to keep the economy stable by managing the money supply and interest rates.
Step-by-step explanation:
Maintaining price stability is a crucial function of the European Central Bank (ECB). This involves using monetary policy to keep inflation low and stable. Inflation targeting is a strategy where the central bank sets a target inflation rate and adjusts monetary policy to achieve that rate. This focus helps minimize the risk of exchange rate fluctuations while promoting both domestic and international competition. A central bank strives to prevent high inflation or deep recessions through low and reasonably steady interest rates.
Monetary policy, however, has its limitations due to factors such as the lag time in the effects of policy changes, banks' decisions to hold excess reserves, and unpredictable shifts in the velocity of money. The equation MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the economy's real output, illustrates the relationship between these factors. By targeting inflation, the ECB can contribute to economic conditions that foster exchange rate stability.