Price Stability
Expert reviewed • 14 August 2024 • 9 minute read
What is Price Stability?
Price stability is a fundamental objective of economic policy, playing a crucial role in maintaining economic health and fostering sustainable growth. Price stability refers to a state where the general price level in an economy remains relatively constant over time, with low and stable inflation. Central banks, including the Reserve Bank of Australia (RBA), typically target a low, positive rate of inflation rather than zero inflation. The RBA's target band for inflation to achieve price stability is between 2-3%. This rate ensures the avoidance of high inflation, which erodes purchasing power, and deflation, which can lead to reduced economic activity and increased unemployment.
What is the Importance of Price Stability?
Maintaining price stability is crucial for several reasons:
- Stable prices provide a conducive environment for economic growth by reducing uncertainty, encouraging investment, and facilitating long-term planning. This increased economic certainty increases economic growth as it allows businesses and consumers to make informed long-term decisions.
- Maintaining stable prices protects the purchasing power of consumers, ensuring that their money retains its value over time. If inflation was to spiral out of control, the purchasing power of the consumer would decrease as wages are unable to grow at the same rate. This was seen in the Australian economy, post-COVID, where inflation reached a high of 7.8%, while wage growth was only 3.3%.
- Price stability also contributes to a stable financial system by preventing asset bubbles and financial crises. This comes as a result of more predictable interest rates, benefiting borrowers and investors. Interest rates become more predictable, as the RBA does not have to continuously implement cash rate changes to account for inflation.
What are the Challenges in Achieving Price Stability?
Achieving and maintaining price stability presents several challenges:
- External factors such as oil price shocks, natural disasters, and global economic conditions can impact domestic price levels. For example, the Russia-Ukraine war and bad trade relations with China have led to imported inflation. This is seen in Australia's import prices increasing by 6.2% in the year to June 2023.
- Additionally, supply chain issues, such as those experienced during the COVID-19 pandemic, can lead to shortages and price increases. This can also lead to imported inflation and cost-push inflation. For example, if it is more expensive for a domestic firm to import production components from overseas, they must adjust their prices to consumers accordingly.
- Structural changes in the economy, such as technological advancements and shifts in consumer preferences, can impact price stability. For example, the rise of e-commerce has changed retail pricing dynamics, influencing inflation trends. Companies such as eBay and Amazon allow consumers to purchase items from the luxury of their home, generally for cheaper prices.
What are the Policies Used to Maintain Price Stability?
Central banks and governments employ various strategies to achieve and maintain price stability:
Monetary Policy
The RBA influences price stability through various monetary policy rate channels, such as the interest rate channel. By adjusting the overnight cash rate, the RBA influences banks' consumer interest rates. To maintain price stability (i.e. limit inflation) the RBA increases the cash rate, which is passed onto consumers as increased interest rates. As a result of increased repayments to banks for people who have loans, their consumption is reduced. This reduces aggregate demand, and hence inflation. This is evident in Australia's recent economy, where due to cash rate hikes from 0.1% in 2020 to 4.35% as of 2024, inflation has decreased from 7.8% in 2022 to 3.6% in 2024.
Fiscal Policy
Governments use taxation and spending policies to manage aggregate demand and influence price levels. For example, during periods of high inflation, the government may reduce spending or increase taxes to cool down the economy. In response to the 7.8% inflation rate in the fourth quarter of 2022, Australia's 2023-24 Federal Budget introduced fiscal consolidation measures to complement the Reserve Bank's monetary policy. Key actions included reducing discretionary public spending, implementing targeted tax increases on high-income earners and large corporations, and focusing on debt reduction. The government also maintained funding for essential social programmes like affordable housing and healthcare. These efforts aimed to decrease overall demand, lower the fiscal deficit, and support price stability, creating a balanced approach to managing inflation and stabilising the economy.