# Price level stability

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Price level stability (wrongly also price stability ) means the constancy of the price index of a bundle of goods that is produced or consumed in an economy. This is fulfilled if the price level does not or hardly changes within a certain time interval . The current price level is compared with the price level of a previous period. As part of the magic square, price level stability is an important economic policy goal. It is named as a goal, for example, in the EC Treaty ( Art. 2 ), in the Statute of the European Central Bank , in the German Basic Law ( Art. 88 ) and in the Stability and Growth Act (1967).

## Components of price level stability

Securing prices at a constant price level includes both a domestic and an external element. Both must run in the same direction, not necessarily in the same direction. Rather, a currency can have a solid intrinsic value, while its external value (= its value against other currencies ) decreases.

### The domestic element

The domestic economic element is the gross domestic product . It is made up of quantity-price components. The extent to which there is price level stability can be measured with a price index . Indices for consumer prices, industrial prices, industry prices, import prices or the GDP deflator are ideal . In order to be able to make statements about a general price level stability, a price index as broad as possible is necessary. Many central banks therefore use a consumer price index .

The (nominal) gross domestic product adjusted for price changes is referred to as real gross domestic product. It can be calculated from the nominal gross domestic product using the following formula:

• ${\ displaystyle \ mathrm {BIP} _ {\ text {real}} = {\ frac {\ mathrm {BIP} _ {\ text {nominal}}} {\ text {price index}}} \ cdot 100}$

Price level stability enables entrepreneurs to forecast costs and revenues over the long term ( budgeted costs , budgeted revenues ). Sharply rising prices endanger the monetary functions by creating uncertainty among buyers and entrepreneurs and lead to imbalances, since owners of tangible goods (retain their value) and debtors (their debts lose value) benefit from inflation , while creditors are disadvantaged.

Deflation, on the other hand, disadvantages debtors and favors creditors, which can lead to debt crises. If economic agents exercise reluctance to buy in anticipation of further wage and / or price cuts, a deflationary spiral can result.

### The external economic element

Price level stability has an external aspect, exchange rate stability . Two factors are particularly important here: on the one hand, the exchangeability of a currency, the so-called convertibility , and on the other hand, the price formation of a currency with the help of an exchange rate system .

“Full convertibility is the unlimited exchangeability of a currency for foreign currencies by residents and foreigners, free from state regulations, regulations and restrictions.” Here it is irrelevant whether the exchange of currencies into foreign currencies takes place at a fixed or flexible exchange rate . However, convertibility may be limited in some cases. One should mention here the domestic convertibility, in which a trading of currencies is only permitted for residents.

Changes in exchange rates arise due to fundamental changes in the supply and demand for foreign currency, but also as a result of speculative supply and demand developments. The supply of foreign currency in Germany is called the foreign exchange supply. A change in the supply of foreign exchange occurs, for example, through the export of goods by domestic companies, through capital imports or through direct investments by foreign companies in Germany. Foreign exchange demand is the domestic demand for foreign currency. A change in the demand for foreign exchange results, for example, from imports of goods by domestic companies, from capital exports or from direct investments by domestic companies abroad.

## Delimitation of the term

Price level stability is often equated in common parlance with the terms price stability and monetary stability .

In today's society one hardly distinguishes between price stability and price level stability. It is not entirely irrelevant to differentiate between the individual prices of goods and services and the general price level. Slight changes in individual prices are common in a market economy, even when overall price stability prevails. Because of this, price level stability must actually stand instead of price stability. If the aim were to achieve price stability, then fixed market conditions would ultimately be eliminated. It is an expression of the free play of market forces that individual prices rise over time, others fall and others remain constant. Rising and falling prices of individual goods and services are thus an expression of an increase or decrease in demand and supply as well as structural reorganizations. Such changes in individual prices are unavoidable for adjustment processes to meet such demands. The aim of price level stability is therefore to keep the total value of a basket constant, but not every single price of the numerous goods and services contained in this basket.

However, both terms are treated as equivalent in general literature. The Council of the European Central Bank defines price stability "as an increase in the harmonized index of consumer prices (HICP) for the euro area of ​​less than but close to 2% compared to the previous year."

## Importance of price level stability

"Price level stability is one of the most important economic policy goals because it is essential for social peace and the functioning of a market economy."

Price level stability is essential for social harmony so that people can secure their money . Nowadays man does not have to invest the income he earns in the same period in which he earns it. He can save money, for example to use it later for planned business, travel or even for retirement. At the time of saving, portions of the saved income have a certain purchasing power. However, purchasing power is only maintained if the price level does not change. If, however, prices then rise, the purchasing power of the saved income decreases. In extreme cases, the money saved can lose almost all of its purchasing power.

Price level stability is also important for the functioning of a market economy , because in this way constant economic development can be maintained. In the market economy, the price mechanism regulates which investments are made and when. If the real demand for certain goods or services increases, but at the same time the supply is kept unchanged, then the prices of these goods rise. As a result, companies invest in these goods because they hope for higher profits; in addition, the growing real demand is satisfied. If, on the other hand, the overall price level rises, companies could take this as a sign of increasing real demand and expand their investment activity. In reality, however, only the price level rises, but not the real demand. If , on the other hand, companies also invest as a result of inflationary developments, the newly generated capacities would not be able to be used due to a lack of real demand. As a result, many companies would be insolvent and would have to file for bankruptcy. This would stall the steadfastness of economic development.

## Price level stability in the European Union

As part of the European Monetary Union, the price level stability in the euro zone is controlled with the help of the consumer price index (CPI-EMU). This results from the weighted mean of the harmonized consumer price indices of the member states. The European Central Bank has stated that the primary goal of price level stability is an inflation rate of less than 2 percent. Securing price level stability has become a core task of monetary policy internationally in recent years.

## literature

• Peter Bofinger, Juliane Reischler, Andrea Schachter: Monetary Policy, Goals, Instruments and Strategies . Vahlen, Munich 1996, ISBN 3-8006-2017-0 .
• Reiner Clement, Wiltrud Terlach: Fundamentals of applied macroeconomics: A connection between macroeconomics and economic policy . Vahlen, Munich 1998, ISBN 3-8006-3142-3 .
• Claus Köhler: Price stability and full employment in a global economy: The contribution of a potential-oriented money u. Credit policy . Verlag Moderne Industrie, Munich / Landsberg, Lech 1996, ISBN 3-478-39830-4 .
• Ullrich Teichmann: Outline of the economic policy. 4th edition. Vahlen, Munich 1998, ISBN 3-8006-2191-6 .

## Individual evidence

1. Reiner Clement, Wiltrud Terlach: Foundations of applied macroeconomics: A connection between macroeconomics and economic policy . Vahlen, Munich 1998, p. 118.
2. ^ Heinz-Dieter Smeets: Price level stability. In: Lexicon Social Market Economy. UTB, 2002, p. 337.
3. European Central Bank, 2006.
4. Claus Köhler: Price stability and full employment in a global economy: The contribution of a potential-oriented money u. Credit policy . Verlag Moderne Industrie, Munich / Landsberg, Lech 1996, p. 53.
5. ^ W. Buchwald: The harmonization of the consumer price indices in Europe. (= List Forum. Volume 24). Pp. 1-2.