Why is price stability important?

I/ How is inflation measured?

Inflation is the average general rise in the prices of goods and services, i.e.  in average, the rise in the prices of some products is more important than the decrease in the prices of other products. Inflation is generally measured on a 12-months-period.

There are two methods to measure inflation: to deflate the GDP or the Consumer Price Index (CPI). The latter is commonly used by the statisticians. How does it work? 

First of all, a basket of goods and services (the “household’s basket”) is determined. It represents the average consumption of a given population. That way, we take into account the fact that some products are bought much more often than other products, and also the fact that some are much more expensive than others. So, the price evolution of bread and of cars will be dealt with differently.

Then, the price of this “household’s basket” is measured at different moments: usually each month, in order to be able to publish monthly statistics.

So, we can measure inflation from one year to another with the following formula:

(Prices during year N – Prices during year N-1) / Prices during year N-1.

Example: my “household’s basket” costs 100 € in 2011 and 105 € in 2012. Inflation is (105-100)/100 = 5%.


II/ What are the costs of inflation?

Inflation has several costs for the economy and for society.

First of all, inflation contributed to redistributing wealth to the disadvantage of people who have an income not indexed on inflation (usually savers and some lenders) and to the benefit of people who have debt not indexed on inflation.

Indeed: Real interest rate = Nominal interest rate – Inflation rate.

That said, this problem is less acute today, as a lot of incomes are, in one or another way, indexed on inflation.

What is more, a rise in domestic prices reduces the competitiveness of national products compared to foreign ones. This often leads to decreasing exports, destabilizing the balance of trade.

Furthermore, inflation confuses price signals. Indeed, a product’s price should rise only if demand increases more than offer.

Moreover, inflation can lead to a vicious circle. As people anticipate inflation, they ask to be given a rise to avoid a loss of purchasing power. Further to this wages’ rise, businesses will really put up their prices, in order to keep constant margins of benefits. So, anticipated inflation realizes itself, which reinforces people in asking for a rise, etc.

Finally, we may mention the fact that if prices change too often material costs (e.g. changing the tickets) increase.

The CPI has nevertheless some flaws:

– It does not take into account inequalities (of income, of health, etc.) among consumers.

– Because of the stability of the “household’s basket” during a rather long period, it does not take into account the substitution effect. Indeed, if a product gets too expensive, consumers tend to look for a cheaper substitute. So, the CPI is expected to overestimate inflation.

III/ Why do many people think that inflation is higher than it really is?

One reason is that we buy much more often products whose price increased, such as food and energy, than products whose price has decreased, such as high-tech products. However, as the latter are much more expensive, they carry some weigh within the “household’s basket” and contribute to restraining the inflation rate.

Moreover, we care more about higher prices than higher quality. So, if the quality of a product improves while its price remains the same, it benefits the consumer who does not really notice it…

What is more, the perception of inflation depends on individual consumption habits. Smokers, for example, will be strongly hit by an increase in the price of tobacco, while non-smokers won’t care at all.

Furthermore, nowadays, everyone wants to own several high-tech products (mobile phone, flat screen televisions, computers …) that cost a lost compared to fashionable products 20 or 30 years ago.

Finally, while most index measure inflation at an annual rate (i.e. on a 12-months basis), many people (especially elder ones) tend to compare with prices 10 or 15 years ago.

The reality is the following: in France, the purchasing power increased by 5.7% a year between 1960 and 1974 and by 2.1% a year since then.

Remember also that the introduction of the euro has no responsibility in an alleged hidden inflation, as it is impossible to hide price increases to statisticians (except by applying different prices than the apparent ones).

IV/ Some figures…

As we are not able to download a table on the blog, please click here to find statistics by Eurostat about the inflation in May 2012 (see the second page of the document).

V/ However, deflation is also bad…

Deflation is “negative inflation”, i.e. an average general decrease in the prices of goods and services.

One might think that it is good for consumers, as they will buy cheaper products, but it is wrong.

Indeed, if prices are decreasing, consumers will decide to wait a bit longer before buying, as they will expect even lower prices a few weeks or months later.

But if everyone thinks the same, businesses cannot sell anymore their products. So, unemployment rises and the economy is in recession.

This vicious circle ends when an economic policy to stimulate demand is enforced or when prices are so low that consumers do not defer anymore their purchases.

That’s it for this first article explaining the economic models and theories on which my articles (particularly the ones where I express opinions and judgments) are based. Several others will follow…

Pierre-Antoine KLETHI

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