Business, Politics, & Society

Learn About Price Stability in Economics: Quantitative Definition, Benefits, and Consequences of Inflation and Deflation

Written by MasterClass

Last updated: Sep 16, 2019 • 4 min read

In an open market, price levels are driven by supply and demand—as supply and demand rise and fall, so do consumer prices. However, when severe fluctuations occur in general price levels, an economy’s financial stability is at risk. That’s why governments and banks work to maintain something called price stability.

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What Is Price Stability?

Price stability is when the general level of prices in the economy avoid significant fluctuations, meaning they don’t rise or fall drastically in indexes of prices like the Consumer Price Index (CPI) or the Harmonised Index of Consumer Prices (HICP).

What Is the Quantitative Definition of Price Stability?

In 1998, the European Central Bank (or ECB) implemented a quantitative definition of price stability, in order to be as specific as possible about what constitutes “significant fluctuation” in prices:

“Price stability is a year-on-year increase in the [HCIP] of below 2%.”

The ECB also specified that “price stability is to be maintained over the medium term,” which is a term between one and three years, as opposed to short term (under one year) or long term (over three years).

Why Is Price Stability Important?

Price stability is vital to economies because price levels determine inflation and deflation—inflation is defined as an increase in prices and a decrease in the value of money, while deflation is a decrease in prices and an increase in the value of money. In other words, when prices increase (usually measured over the course of a year), it’s called inflation, and when prices decrease, it’s called deflation.

Severe, rapid, or unexpected inflation rates and deflation rates are major threats to economic growth because they alter the value of money. This is why the ECB recommends a slow and steady rate of inflation “below, but close to, 2% over the medium term.”

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What Are the Consequences of Inflation?

When high inflation occurs, the price of good increases while the value of money decreases. This, in turn, causes wages, savings, and purchasing power to decrease in value. During times of severe inflation, consumers become frightened and aggregate demand declines, which causes businesses to lose out on profits and let employees go, compounding the public’s fear.

What Are the Consequences of Deflation?

When deflation occurs, the price of goods decreases while money increases in value. During times of severe deflation, loans are paid off with money more valuable than it was when the loan was taken out, which leads to an increase in unpaid loans, causing debt crises and bankruptcies.

Another consequence of deflation is that the public will postpone spending in anticipation of even lower prices, yet again causing businesses to lose out on profits and let employees go.

What Are the Benefits of Price Stability?

Price stability means an economy can avoid severe inflation and severe deflation. This causes many significant benefits:

  • Improves price transparency. With stable prices, consumers can recognize relative price changes without being confused by overall price changes (for instance, consumers will notice when the price of apples increases compared to oranges). This means informed decision-making when they consume and invest.
  • Avoids arbitrary redistribution of wealth. When unexpected inflation occurs, wealth is redistributed randomly, rather than based on merit or need: for instance, different goods’ prices increase at different rates, which punishes certain businesses more than others, and creditors receive less in loan payments than they would have with low inflation, while debtors benefit from inflation. With price stability, this arbitrary redistribution of wealth is avoided.
  • Lowers risk premia. A risk premium is the lowest return on investment a consumer needs in order to hold a risky asset rather than a risk-free one. If risk premia are high, it means consumers are unwilling to make risky investments, and economic activity slows. If risk premia are low, real interest rates are lower and consumers feel more comfortable with investment decisions, which leads to economic growth.

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How to Maintain Price Stability: Fiscal Policy

The government’s tool to ensure stable prices is fiscal policies, which involve adjusting tax rates or government spending.

Fiscal policies work well to combat both inflation and deflation because the government can use taxes and spending to either increase or decrease the amount of money their citizens have access to, either increasing or decreasing the value of the money itself.

How to Maintain Price Stability: Monetary Policy

A central bank (like the U.S. Federal Reserve, known as the Fed) works to maintain stable prices with monetary policy, which involves adjusting the bank’s interest rates on loans to consumers and businesses.

While monetary policy works well to combat inflation, it isn’t effective against deflation, because loans taken out during deflation have to be paid back with currency worth more than it was when the loan was taken out. This is why a slow and steady inflation rate is best for an economy—it keeps the nominal interest rate above zero and allows banks to contribute to price stability.

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