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.
What is price stability?
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.
Why is price stability important?
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.
Negative effects of inflation
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.
Negative effects of deflation
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.
The best price stability examples
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.
- Groceries - This is an area where are often noticed first. During times of high inflation, it's much more expensive to purchase groceries than it otherwise is. Although regular dynamics can creep a grocery bill up, the variety of goods purchased often evens out regular market dynamics.
- Housing market - Ideally, real estate will appreciate in value. Even for those who don't see it as an investment, the ability to sell your house without losing money is expected. During times of rapid inflation, consumers may pay more for a house than it will be worth as prices stabilize. Deflation can lower the value of a home below what is owed on it.
- Building materials - We recently saw the effects of supply chain disruptions raising the cost of building materials. This caused the costs of home repairs to rise dramatically as contractors were forced to pass prices on to consumers.
4 key benefits of price stability
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 transparency
Prices will always change. But with price stability, consumers will be able to recognize when a given good is going up and down in price, and make more informed decisions about their purchases. When everything is moving in price, it becomes harder for consumers to adapt. Clearer pricing developments associated with greater price stability reduces hesitation on the part of the consumer.
- Avoids random wealth redistribution
When prices are changing outside of typical supply and demand forces, there are winners and losers that have little control over their circumstances. An example from earlier, how inflation from the pandemic hurt the construction industry particularly hard, illustrates how revenues can change disproportionately.
- Low risk premia
Another example from above illustrates this example. When the housing market is affected by inflation, it will have an impact on the number of people willing to take a risk on investment. This slowing of investment applies to the business sector as well, resulting in lower economic growth than occurs at more stable prices.
- Reduced unproductive investment activities
The risk premia calculation mentioned above certainly affects how investors behave, and results in them making fewer worthwhile investments. However, attempts to get ahead of inflation or deflation can have the opposite effect. For example, a company might purchase more supplies than they need to avoid paying more later.
How price stability is measured
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.
Best ways to maintain price stability
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.
Price stability FAQs
What is the price stability objective?
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%.
Why is Consumer Price Index (CPI) used to show price stability?
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.
What is a good price level stability?
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.