Discuss why policy makers have become more concerned with maintaining a stable price level as a goal of economic policy?

 

(Question) Discuss why policy makers have become more concerned with maintaining a stable price level as a goal of economic policy?

Answer:

The policy makers have become more concerned in maintaining the price stability because of the significant effect of disadvantages of inflation and at the same time deflation in the economy of the nation as a whole. The overriding importance of the price stability for the policy makers is its objective in monetary policy mirrors the broad consensus among economists that monetary policy only has a temporary impact on real economic variables (such as e.g. economic growth and unemployment). In the long run, monetary policy only has an influence on monetary variables; this means that steering the increase of price levels (i.e. the inflation rate) naturally falls within the remit of monetary policy makers.

Price stability proves beneficial for the economy in several ways:

• It makes it easier for people to disentangle changes in prices of individual goods or services from changes in the general price level. This in turn allows the market to allocate resources more efficiently.
• If prices are stable, inflation risk premiums in financial markets go down, which means that real interest rates go down as well. Lower interest rates, in turn, increase the incentives to invest.
• In an environment of price stability, businesses and other economic agents do not have to hedge against inflation and can therefore put the available resources to productive use.
• The nominal orientation of tax and social security systems creates distortions in the economy, which may be kept in check by lower inflation.
• Price stability reduces the arbitrary redistribution of wealth and income that arises in inflationary and deflationary environments.
• Price stability contributes to financial stability.

Price stability contributes greatly to the economy of the country such as improving the transparency of the price mechanism. Under price stability people can recognize changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently;

In addition, it works on reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest. Lastly, it's better to have a stable price level compare to a fluctuating and often changing price level.