4.6 Price stability

Price stability refers to a situation where the general price level in an economy is stable or rising very slowly, typically with low and predictable inflation.

Definitions

  • Inflation: A sustained increase in the general price level over time, reducing the purchasing power of money.
  • Deflation: A sustained fall in the general price level, increasing the real value of money.
  • Disinflation: A fall in the rate of inflation (prices are still rising, but more slowly).

Measurement of Changes in the Price Level

Consumer Price Index (CPI)

  • CPI measures the average change in prices of a basket of goods and services consumed by households.
  • Steps:
    1. Select a basket of goods
    2. Assign weights based on importance
    3. Track price changes over time
  • Inflation rate: Inflation rate=CPI this year – CPI last yearCPI last year×100\text{Inflation rate} = \frac{\text{CPI this year – CPI last year}}{\text{CPI last year}} \times 100

Difficulties in Measuring CPI

  • Changing spending patterns: Basket may become outdated
  • Quality changes: Hard to separate price rises from quality improvements
  • New products: Not immediately included
  • Substitution bias: Consumers switch to cheaper alternatives
  • Weighting inaccuracies: Not all households have same spending habits

Nominal vs Real Values

  • Nominal values: Measured in current prices (not adjusted for inflation)
  • Real values: Adjusted for inflation, showing true purchasing power

Example:

  • Income rises by 5%
  • Inflation = 3%
    → Real income increase = 2%

Causes of Inflation

Demand-Pull Inflation

4Occurs when aggregate demand (AD) increases faster than aggregate supply (AS)

  • Causes:
    • Rising consumer confidence
    • Increased government spending
    • Low interest rates
    • Export growth

→ “Too much demand chasing too few goods”

Cost-Push Inflation

Occurs when costs of production increase, shifting AS left

  • Causes:
    • Higher wages
    • Increased raw material prices (e.g. oil)
    • Higher taxes on firms

→ Leads to higher prices and lower output

Consequences of Inflation

Negative Effects

  • Loss of purchasing power: Real incomes fall
  • Uncertainty: Harder for firms to plan
  • Menu costs: Cost of changing prices
  • Shoe leather costs: Costs of managing cash
  • International competitiveness falls: Exports become more expensive
  • Redistribution effects:
    • Savers lose
    • Borrowers gain

Positive Effects (if low and stable)

  • Encourages spending and investment
  • Avoids deflation
  • Allows real wage adjustments

Evaluation

  • Low, stable inflation (e.g. 2%) is generally desirable
  • High inflation causes major economic instability
  • Deflation may be worse:
    • Delayed spending
    • Falling output
    • Rising unemployment

Quick Summary

  • Inflation = rising prices
  • Deflation = falling prices
  • Disinflation = slower inflation
  • CPI measures price changes
  • Nominal ≠ real values
  • Causes:
    • Demand-pull (AD ↑)
    • Cost-push (AS ↓)
  • Effects:
    • Depends on size and stability of inflation