Why Price Stability?

Price stability, next to economic growth, full employment and an internal as well as external balance, represents one of the five objectives of economic policy. As part of the division of labor among economic policymakers, the responsibility of achieving and maintaining price stability has been entrusted to the central banks. Article 105 of the Treaty of Rome stipulates that maintaining price stability is the primary objective of the Eurosystem. 

The objective of price stability refers to the general level of prices in the economy and implies avoiding both a substantial increase in the price level (inflation) and a permanent decline in the price level (deflation). Price stability has such high priority within economic policy because as part of the financial framework for a country’s economic activity it ensures stable and predictable conditions which, in turn, have a positive impact on economic activity and the employment rate. By contrast, a continued increase in the price level entails a series of unfavorable effects on private households and businesses and consequently on the economic and social cohesion of a society.

In detail, there are six reasons why price stability has a positive impact on economic activity: 

• First, price stability makes it easier for people to recognize changes in the relative prices of various goods and services, since such changes are not obscured by fluctuations in the overall price level. As a result, businesses and consumers do not misinterpret general price changes and are able to make better informed consumption and investment decisions. This then allows the market to allocate resources more efficiently. By helping the market to steer resources to where they can be used most productively, price stability increases the productive potential of the economy and thus the welfare of households.
• Second, if creditors can be sure that prices will remain stable in the future, they will not demand an inflation risk premium to compensate them for the risks associated with holding nominal assets over the longer term. Lower risk premiums on real interest rates render monetary policy more credible and thus increase the efficiency with which capital markets allocate resources and make investing more attractive. This in turn fosters economic growth.
• Third, credibly maintaining price stability also keeps individuals and businesses from diverting resources from productive uses in order to hedge against inflation. A high-inflation environment, for example, provides an incentive to stockpile real goods since they retain their value better in such circumstances than money or certain financial assets. However, stockpiling goods is not an efficient investment decision and therefore impairs economic welfare. 
• Fourth, tax and welfare systems can create perverse incentives which distort economic behavior. In most cases, these distortions are exacerbated by inflation, as progressive, nominal income-oriented fiscal systems lead to higher average taxation over time when the price and income levels increase. Price stability eliminates the costs of this so-called bracket creep phenomenon. 
• Fifth, inflation acts as a tax on cash inventory. This reduces household demand for cash and consequently generates higher transaction costs (such as more frequent bank visits). 
• Sixth, maintaining price stability prevents the considerable and arbitrary redistribution of wealth and income that arises in inflationary as well as deflationary environments, where price trends change in unpredictable ways (e.g. redistribution effects from creditors to debtors with unforeseen inflation). Typically, the weakest groups of society suffer the most from inflation, as they have only limited possibilities for hedging against it. An environment of stable prices thus helps maintain social cohesion and stability. As several examples in the twentieth century have demonstrated, high rates of inflation or deflation often create social and political instability.  

All these arguments suggest that a central bank that maintains price stability substantially contributes to achieving broader economic goals, such as higher standards of living, high levels of economic activity and a greater number of jobs.

When the monetary policy strategy of the ECB was evaluated in the first half of 2003, the advantages of price stability and the problems caused by high inflation were documented in numerous studies. Here are some links to these studies.