Price stability

From CEOpedia | Management online

Price stability'- the state of the financial system, covering all financial markets and the infrastructure supporting them, in which it performs its functions in a continuous and effective manner, even in the event of unexpected and adverse disturbances of a significant scale

Functions of price stability

Maintaining the stability of the financial system is a prerequisite for sustainable economic growth, and the condition of the banking sector is in the spotlight, as it plays a key role in the national financial system. An inseparable part of the above definitions are the functions of the financial system. J.G. Schinasi distinguishes the following functions of the financial system:

  • 'effective and efficient allocation' of financial resources (between entities managing accruals), i.e. the process of financial intermediation,
  • 'correct valuation', allocation and financial risk management.

The above classification emphasizes the importance of the financial intermediation function through which a stable financial system supports economic development. An important function of the financial system is also the payment function, which concerns ensuring smooth flow and access to money. It depends, among others on the security and efficiency of the payment system supervised by the central bank, and its disturbance may negatively affect confidence in money. The functions fulfilled by the financial system can therefore be associated with the functions fulfilled in the economy by money, and in particular with the payment, circulation, value measure and thesaurizing function.

Benefits od proce stability

The price stability objective refers to the general price level in the economy. This means avoiding both long-term inflation and deflation. Price stability contributes to achieving a high level of economic activity and employment through:

  • to improve the transparency of the price mechanism. In terms of price stability, people can recognize changes in relative prices (i.e. Prices between different goods), without confusing changes in the general price level. This allows them to make informed decisions on consumption and investment, and effectively allocate resources;
  • avoiding unproductive measures to safeguard against the negative effects of inflation or deflation;
  • lowering the inflation risk premium in interest rates (i.e., creditors are asking for compensation for the risk associated with owning nominal assets). This reduces real interest rates and increases the incentives to invest;
  • arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation;
  • limiting distortions of inflation or deflation that may exacerbate the disruptive effect on the economic behavior of tax and social security systems prevention;
  • contributing to financial stability.

Although the Treaty explicitly establishes price stability as the main objective of the ECB, it does not specify what is meant by price stability.

Quantitative definition of price stability

The Governing Council of the ECB has defined price stability as the annual increase of the harmonized index of consumer prices (HICP) for the euro area below 2%. Price stability should be maintained in the medium term. The Governing Council also explained that, striving for price stability, it aims to keep inflation below, but close to, 2% over the medium term.

Examples of Price stability

  • Price stability is demonstrated when the rate of inflation remains low and stable over a period of time. For example, when the U.S. Consumer Price Index (CPI) stays within a range of 2-3% over a period of years, this indicates that the prices of goods and services are relatively stable.
  • Price stability is also seen when the exchange rate remains constant between two countries, such as the U.S. dollar and the euro. When the exchange rate remains relatively stable, it indicates that the prices of goods and services in the two countries are not fluctuating significantly.
  • Price stability is also seen when the stock market is not subject to large fluctuations. When the stock market remains relatively stable and prices of stocks do not fluctuate significantly, it indicates that the prices of goods and services in the economy are not changing dramatically.

Limitations of Price stability

Price stability is a desirable outcome in the financial system, but it is not without its limitations. These include:

  • It is difficult to achieve a balance between price stability and economic growth. If prices are too stable, it can lead to an overall decrease in economic activity, while if they are too volatile it can lead to instability and a lack of confidence in the financial system.
  • Price stability can also be affected by external factors such as changes in inflation, interest rates, and global economic conditions. These factors can lead to large swings in prices, making it difficult to maintain price stability over time.
  • Price stability also requires a stable money supply, which is not always possible. Unexpected changes in the money supply can lead to inflation or deflation, making it difficult to maintain price stability.
  • Finally, it is difficult to ensure that prices are stable across different markets. Imbalances in supply and demand can lead to large price swings, making it difficult to maintain price stability.

Other approaches related to Price stability

  • Price Stability is an important concept for the financial system to function properly. Other approaches related to Price Stability include:
  • Monetary Policy: Central banks use monetary policy to manage the supply of money in an economy in order to maintain price stability. This includes setting interest rates and quantitative easing.
  • Fiscal Policy: Fiscal policies are used to manage government spending and taxation in order to ensure price stability. This can include tax cuts, increases in government spending, and debt management.
  • Financial Regulation: Financial regulation is used to ensure that the financial system functions efficiently and does not lead to excessive price volatility. This includes setting capital requirements for banks, setting limits on leverage, and regulating derivatives markets.
  • Asset Price Monitoring: Asset prices such as stocks and bonds can have an important impact on price stability. Central banks and other regulatory bodies monitor asset prices to ensure that they do not lead to excessive volatility.

In conclusion, Price Stability is an important concept for the financial system to function properly. To ensure Price Stability, a variety of policies and regulations can be used, including monetary policy, fiscal policy, financial regulation, and asset price monitoring.


Price stability — recommended articles
Currency Convertibility — Monetarism — Expansionary monetary policy — Money emission — Public funds — International liquidity — Global demand — Net Borrower — Emerging market economy

References

Author: Martyna Sołtys

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