What is Price Stability?

John Spacey, May 19, 2018

Price stability is when general price levels in an economic system change little over time.

Inflation vs Deflation

Inflation is a sustained increase in general price levels. Deflation is the opposite, a sustained decrease in general price levels. Low levels of inflation or deflation below 2% may be viewed as price stability.

Inflation & Growth

Inflation is often viewed as better for an economy than deflation because a low level of inflation may stimulate economic growth. When prices are always rising a little, people have incentive to invest their money as opposed to saving conservatively. Inflation also encourages consumption because you are less likely to delay purchases when prices are likely to rise.

Deflation & Savings

Deflation benefits people with savings because they do not have to take risks to preserve the value of their money. Deflation encourages people to save because the value of money is always going up as things get cheaper. In this sense, deflation benefits the old as they are more likely to have savings. Inflation may benefit the young as it may stimulate employment.

Monetary Policy

Price stability is a common goal of monetary policy. However, in practice monetary policy is often aimed at producing mild inflation as opposed to zero inflation. Generally speaking, lower interest rates and more liquidity in a system cause inflation and prevent deflation. Conversely, increased interest rates and less liquidity help to prevent inflation.

Fiscal Policy

An expansionary fiscal policy that involves a government spending more than its tax revenues can contribute to inflation. The opposite effect is a contractionary fiscal policy that involves a government spending less than its tax revenues to pay down debt.

Deflation & Innovation

It is quite common for innovation to reduce prices. For example, an improvement in farming methods may greatly increase the supply of food, driving down prices.

Deflation & Globalization

Globalization can cause deflation as it allows things to be produced at greater scale. For example, it is cheaper for one country to produce 1 billion solar panels than for every country to produce a few million solar panels.

Price Instability & Economic Efficiency

Price instability is a rate of inflation or deflation higher than about 2%. It is possible for both high inflation and deflation to damage the economy of a nation. High inflation encourages hoarding of goods and can lead to a break down in economic efficiency. Likewise, deflation encourages the hoarding of money. This also harms economic efficiency by discouraging spending and investment.