Why Governments Worry When Price Stability Is Not Achieved

Question

In Japan, any sign of falling general price levels will lead to swift implementations of various policies to combat deflation. On the other hand, hyperinflation in Zimbabwe has worsened to a point where its residents are resorting to making transactions with other countries’ currencies instead.

Explain why governments are worried when price stability is not achieved. [10]

Answer

Price stability is a low, stable and expected rate of increase in the general price level. When it is not achieved there is either high inflation or deflation, and governments worry about both — the first because it erodes welfare and can trigger stagflation, the second because it can spiral into a self-reinforcing contraction.

High inflation — demand-pull. Demand-pull inflation, driven by a rise in aggregate demand, raises the general price level.

Demand-pull inflation: aggregate demand rises from AD₀ to AD₁ along the upward-sloping range, raising the general price level from P₀ to P₁ as output rises from Y₀ to Y₁. The rise in the price level erodes consumers' real income and purchasing power.

As the general price level rises from P₀ to P₁, consumers’ purchasing power and real income fall, so the quantity and quality of goods they can buy falls — material standard of living declines.

High inflation — cost-push and stagflation. Cost-push inflation, driven by a rise in production costs, is worse still: real national output falls while the price level rises — stagflation. Material standard of living falls doubly, since prices rise even as household disposable income falls with national income. As firms’ revenue and profits fall, they cut output and employ fewer factors of production, so demand-deficient unemployment rises.

Deflation. A sustained fall in the general price level is also feared. When prices fall, consumers postpone consumption in anticipation of still-lower prices, and investors postpone investment as confidence and the expected return fall — so C and I both fall. Producers’ revenue and profits fall, they employ fewer factors of production, and demand-deficient unemployment rises. Worse, deflation can become a deflationary spiral: postponed spending lowers profits and employment, falling wages and rising unemployment cut disposable income, which depresses consumption further — a vicious cycle of falling prices and falling expenditure that can deepen into social instability.

In sum, governments worry because the absence of price stability — whether high inflation (eroding living standards and, in the cost-push case, raising unemployment through stagflation) or deflation (risking a self-reinforcing contraction) — damages material standard of living and threatens the other macroeconomic goals.