The Importance of Stable Price Levels

Inflation and deflation are very significant variables in economies and can have noticeable to devastating effects. Many governments and central banks try to regulate changing price levels to stabilize them, in order to avoid the economic consequences. Stable prices are important because of the linkage between inflation, the nominal interest rate, and money demand and supply (Mankiw, 2012, p. 113). Money demand and supply determine the price level, which in turn determines inflation, which in turn determines the nominal interest rate, which cycles back to determining money demand. The interest rate has historically had a positive correlation with the level of prices, and so a change in the level of prices can change the interest rate and therefore all of the variables that the interest rate affects, including investment, consumption, saving, financial markets, GDP and employment (Mankiw, 2012, p. 85). Thus a stable price level is important to ensure other aspects of the economy remain relatively robust at equilibrium levels.

In the short term, inflation acts as a tax, an “inflation tax”, upon the people. The change in the interest rate caused by a change in prices results in a change in the money demanded, thus changing the supply of real money balances. During an increase in the price level, this results in people having smaller supplies of money and thus having to go to the bank more often. This type of consequence of inflation is called a shoe-leather cost (Mankiw, 2012, p. 116). There are also menu costs, which are the result of businesses needing to change their prices. This is inconvenient and costly for businesses to do- some businesses may choose to change prices at different times because of this, resulting in high variability in relative pricing (Ibid.). Additionally, tax laws often do not accommodate in the event of inflation or deflation, often resulting in a greater burden being placed on the taxpayer.

Reference

Mankiw, Gregory N. (2012). Macroeconomics, Eighth Edition. International Version. UnitedStates of America: Worth Publishers.