Everyone has had the experience of going to the store and spending more than you did last time, despite purchasing the same things. This is an example of unstable prices; in this case, inflation. Stable prices make pricing decisions easier to make and reduces uncertainty in the market. In this post, we'll take a close look at what price stability is, and why it's important.
Price stability is when there are no major fluctuations in the prices of general consumer goods. While it's important to note that the law of supply and demand will always result in some fluctuations as market dynamics shift, a stable economy sees those fluctuations moving within a normal range.
One of the most important aspects of a well functioning economy is understanding the value of the money you have. Extreme fluctuations alter the value of money and make it difficult to make purchasing and pricing decisions. These fluctuations can come in two flavors: inflation, where prices go up, and deflation, where prices go down.
When prices rise dramatically, the purchasing power of the individual goes down. When this happens, consumers become more thrifty. The resulting decline in demand has an impact on what companies can get away with charging and can affect revenue.
It may seem as though deflation is good for business, since inflation is bad. This isn't the case. When consumers notice a rapid drop in prices, they'll often hold off on purchases of non-essential items based on the expectation that prices will go lower. So deflation, too, can cause a drop in demand.
Let's take a look at some common ways that price stability affects the average consumer to get a better understanding of how these dynamics work.
We've given some of the broad and immediately recognizable benefits of stable prices. Now let's take a closer look at how businesses, and the economy in general, benefit when price fluctuations are kept to a minimum.
Price stability calculation varies by region. In the United States, for example, the metric used is the Consumer Price Index (CPI). Europe uses a similar metric known as the Harmonized Index of Consumer Prices (HICP). Both of these metrics involve a complicated formula, but at their core they look at a wide cross-section of typical expenditures and measure how those rise or fall year-over-year. Ideally, the fluctuations will be kept under 2%. Fluctuations beyond that can indicate a problem.
Maintaining price stability can come from the government with fiscal policy, or from a central bank with monetary policy. Governments can raise or lower taxes and adjust government spending to influence the amount of disposable money in the system. Central banks, such as the U.S. Federal Reserve, can adjust interest rates on loans to combat inflation.
Some inflation (or deflation) is to be expected. The price stability objective is the target to which the central bank tries to limit these fluctuations. In most cases, this amount is around 2%.
Due to the law of supply and demand and shifting market dynamics, relying on any one category of product to measure inflation can be imprecise. The CPI takes into account a larger range of products to provide a more accurate measure while still providing a consistent metric from which to judge.
A good price stability level will see fluctuations kept under 2% on a year-over-year basis. The measurements are often average over the span of three years to get a medium term outlook.