How could a country achieve currency stability?

Price level stability: definition, meaning and implementation

The price level stability is one of the economic policy goals in the magic square of the social market economy. In this article we give you an overview of the definition and components of price level stability. We also explain why this goal is important for the economy as a whole.

Concept and background

Price level stability refers to the stability of the average price level in an economy. The term does not mean that the prices of the individual goods should be stable. Individual prices can thus go down or up.

It also follows from this that the goal of price level stability is not synonymous with an inflation rate of zero. It is also supposed to avoid deflation. Or to put it simply: The price level should be stable on average.

Inflation: Positive growth rate of the average price level over time.

Deflation: Growth rate of the average price level decreases. Or the average price level falls overall.

Price level stability is a term from macroeconomics. It is often used synonymously with the terms “price stability” or “monetary stability”.

One must differentiate from this goal used in macroeconomic economic policy, the microeconomic price mechanism. In addition, the terminology of currency stability is important. Since we live in an open economy, prices are also influenced by the foreign economy and trade relations.

In this international context, price level stability is a component of currency stability. A distinction is made between two forms:

Internal currency stability = Price level stability

External currency stability = Exchange rate. It measures the stable external value of the currency.

Microeconomic pricing mechanism

The macroeconomic market of an economy consists of many individual markets. This means that the macroeconomic average is determined by developments on the microeconomic level. The characteristics of a market are the two components of supply and demand. The price mechanism then brings both sides into line. The price functions in an economy are diverse.

In addition to the functions for balancing supply and demand, they also play a role in technological progress, innovations and market developments. In order for prices to perform all of their functions, they have to be flexible. If they are rigid, they lose their meaningfulness. Hence there is a discrepancy between the microeconomic level and the importance of fluctuating prices. And the macroeconomic goal of price stability.

Macroeconomic price level stability

Against the background of the microeconomic price mechanism, price level stability does not mean that the overall economic price level is rigid.

It does not refer to the development of the individual prices, but to the stability of the average of the individual prices. And the stable development of the price level.

Price level stability in economic policy

  • Price level stability: stable inflation rate, (and not: inflation rate of zero)
  • Inflation rate: Percentage rate of change of the price level over time.

There is therefore a key difference between the microeconomic and the macroeconomic point of view with regard to the function of prices.

From a microeconomic point of view, flexible prices and price fluctuations are essential for the functioning of the markets. On the other hand, price fluctuations are undesirable from a macroeconomic perspective. It is irrelevant here whether the fluctuations are up or down.

The question arises as to what reasons speak for the fact that price level stability has become such an important economic policy goal.

Aim in the magic square: the importance of price level stability

Price level stability is one of the most important economic policy goals and is firmly anchored in the magic square. In summary, one can say that price level stability is necessary to secure social peace and to ensure the functioning of the (social) market economy. The background to this is the relationship between nominal and real quantities in macroeconomics. And here, above all, the link between the goods and money markets through the price level.

Social peace

Price level stability is a prerequisite for this. Because in this way the functions of money are preserved and the economic subjects have planning security with regard to future economic decisions. This is how we save our money, spend it on trips or invest it in (private) retirement provision. At a certain point in time, our money has a certain purchasing power. If the price level remains constant, the purchasing power of money also remains constant. If the price level changes (inflation), the purchasing power of money also decreases. In the extreme case, you can lose all of your savings. The German experience of hyperinflation shows the importance of price stability for social peace.

Functioning of the market economy

The price mechanism regulates the economic variables in the economy. This means that it determines when, for example, investments are made. For example, if demand increases with constant supply, prices rise. As a result, companies invest to increase their capacities and, above that, production and supply. Because they hope for higher profits. If, however, the overall economic price level rises regardless of demand, the companies invest for free. This means that the investments are not offset by an expansion in demand and thus also no future additional income. In extreme cases, and to put it simply, this inflationary development could lead to companies becoming solvent and insolvent. This would have a negative impact on economic development overall.


Reasons for price level stability

In the following, we will go into more detail on the economic reasons that speak in favor of the macroeconomic goal of price level stability. As explained at the beginning, price level stability does not mean a zero inflation rate. Therefore, one of the reasons for price level stability is avoiding inflation costs as a result of excessive inflation. But also reasons for an inflation rate greater than zero in order to avoid deflation and other negative effects.

Inflation costs

  • Loss of monetary functions
  • Shoe sole and menu costs
  • Planning security
  • Arbitrary redistribution
  • Loss of monetary functions

    High inflation rates reduce the functionality of money. In extreme cases, inflation can mean that money can no longer fulfill its function at all. Examples of this are hyperinflation.

    Money has the following three functions:

  • Transaction function (medium of exchange function)
  • Store of value function
  • Arithmetic unit function
  • Shoe sole and menu costs

    Inflation causes the cost of holding money. Holding money means that you want to hold part of your assets in the form of funds or money. This can be, for example, cash or sight deposits (money in the current account). The higher an expected inflation occurs, the more money loses its real value. As a result, you try to keep as little money as possible. That means you spend time and resources converting your money. The more stable the value of the money, the less these transaction costs are incurred. So there is no inflation. This cost of inflation is also known as the shoe sole cost.

    In addition, inflation causes so-called menu costs. This is understood to mean costs that the providers incur through the announcement of new prices.

    Overall, the higher the inflation rate, the higher the shoe sole and menu costs. In view of the current use of technology in banking, these costs are kept within reasonable limits.

    Planning security

    A stable development of the price level and thus the future exchange value of financial assets is a prerequisite for steady and appropriate economic growth. (also a goal in the magic square!).

    If this stable development is no longer given, the economic agents lose their planning security. You will then not save more or less. Because they can then no longer assess whether the current abstinence from consumption will pay off in the future. If less is saved due to the unstable price level, this means less capital for investments. Investments (savings of economic agents) are then made abroad or only at higher interest rates.

    Arbitrary redistribution

    The consequences of inflation (but also deflation!) Mean that there are winners and losers. This leads to (arbitrary) redistribution, depending on the level of inflation. On the one hand, an unstable price level reduces the willingness to grant and take out loans. This leads to unjustified redistribution effects between creditors and debtors.

    The state is another inflation winner. This is due to the relatively high level of debt and the progressive structure of the income tax rate. But even with a constant tax rate, the state can benefit from inflation. The background is the relationship between inflation and interest rates (see Fisher equation).

     

    Reasons for a positive inflation rate

  • Lubricant function
  • Safe distance to deflation
  • Statistics: Overestimation of the measured rise in price levels
  • Fischer effect: problem of the zero interest rate limit
  • Lubricant function

    Moderate inflation is preferable to zero inflation. Because an increase in the price level facilitates adjustment processes on the goods markets and the labor market. That is why one speaks of a lubricant function of inflation.

    The background to the goods markets is the microeconomic price mechanism. It causes the prices of some goods to rise. With an average price level increase of zero, this would mean that other prices would have to drop sharply. In practice, however, this raises considerable problems. They are mainly due to the fixed nominal wages. Therefore one supports positive inflation rate.

    Safe distance to deflation

    Deflation means that the overall economic price level is falling or a negative inflation rate. In terms of the individual economy or from a buyer's point of view, deflation may be positive. But in macroeconomic terms it is very detrimental to an economy. The key word here is “Attentism”.

    It means that economic agents, in anticipation of falling prices, shift purchasing decisions into the future. In extreme cases, the economy as a whole can be stalled if a so-called deflation spiral occurs. The problem is that deflation can also occur when the average price level rises. Just through the microeconomic price mechanism. Therefore one strives for a positive inflation rate. As a safe distance from deflation.

      

    Statistics: Overestimation of the measured rise in price levels

    Simple measurement problems with the inflation rate also speak in favor of a positive inflation rate. For example, changes in quality in the products can only be reflected in the prices with difficulty. In addition, the prices paid are on average lower than the statistically recorded prices, which is due to price differentiation strategies on the part of the providers. In addition, the representative basket of goods is not made up annually. This means that it is questionable whether the measured inflation rate reflects the actual purchasing behavior of economic agents. The difference between the statistically recorded and instead actually acquired goods is known as substitution bias.


    Fisher Effect: Problem of the Zero Interest Rate

    In macroeconomics, zero interest rate limit means that nominal interest rates cannot go below zero. The limit matters in a recession. Because it implies that monetary policy can reach its limits if it can no longer lower interest rates in order to stimulate the economy. (cf. current ECB policy and the discussion about “penalty interest”).

    The higher the inflation rate, the longer it takes for an economy to reach this zero interest rate limit. This is shown by the so-called Fisher equation and the relationship between nominal and real interest rates. The real interest rate is the nominal interest rate minus the inflation rate. This means that it falls when the nominal interest rate falls or the inflation rate rises. The real interest rate is important for economic agents to make a decision to save or invest.

    For this reason, a positive inflation rate is also preferable. In order to have more leeway in terms of economic policy.

    Conclusion: determining the optimal inflation rate

    The goal of price level stability means a positive and at the same time stable inflation rate in the medium and long term. In the short term, there may well be fluctuations due to the microeconomic price mechanism. The next question is what is the optimal inflation rate. There is no clear answer to this. It depends on the economic framework conditions of an economy how high the safety margin to deflation needs to be. Or how high the inflation can be without the inflation costs outweighing it.

    However, experience and numerous studies have shown a certain pattern:

    In slowly growing and economically highly developed economies, an inflation rate below 1% and above 4% appears to be incompatible with the goal of macroeconomic price level stability. In this respect, the goal of Germany to have an inflation rate of just under 2% lies within the corridor.

    • Price level stability: stable inflation rate, (and not: inflation rate of zero).
    • Inflation rate: percentage rate of change in the price level over time.
    • The goal of price level stability is very important: securing social peace and the functioning of the market economy.
    • Microeconomics: Flexible prices desired in order to guarantee price functions. Macroeconomics: A constant price level is sought.
    • Price level stability requires an “optimal inflation rate”. It must not be too high, but also not too low. The corridor in developed economies is between 1% and 4%.
    • In Germany, the targeted inflation rate to secure macroeconomic price level stability is just under 2%.
    • Kulessa, Margareta. Macroeconomics in Equilibrium, UTB, 2018
    • Fredebeul-Kerin / Koch / Kulessa / Sputek: Fundamentals of Economic Policy, 4th edition, UTB, 2014.
    • Sperber, H .: Understanding the Economy. 112 learning modules on economics, 5th edition, Schäffer-Poeschel, 2016.