Price Stability

The Big B (Ben Bernanke, of course) on price stability :

Price stability plays a dual role in modern central banking: It is both an end and a means of monetary policy.

As one of the Fed's mandated objectives, price stability itself is an end, or goal, of policy. Fundamentally, price stability preserves the integrity and purchasing power of the nation's money. When prices are stable, people can hold money for transactions and other purposes without having to worry that inflation will eat away at the real value of their money balances. Equally important, stable prices allow people to rely on the dollar as a measure of value when making long-term contracts, engaging in long-term planning, or borrowing or lending for long periods. As economist Martin Feldstein has frequently pointed out, price stability also permits tax laws, accounting rules, and the like to be expressed in dollar terms without being subject to distortions arising from fluctuations in the value of money.³ Economists like to argue that money belongs in the same class as the wheel and the inclined plane among ancient inventions of great social utility. Price stability allows that invention to work with minimal friction.

Let me elaborate briefly on the relationship between price stability and the other two goals of monetary policy. First, price stability promotes efficiency and long-term growth by providing a monetary and financial environment in which economic decisions can be made and markets can operate without concern about unpredictable fluctuations in the purchasing power of money. As I have already noted, the dollar provides a reasonably secure gauge of real economic values only when inflation is low and stable. High and variable inflation degrades the quality of the signals coming from the price system, as producers and consumers find it difficult to distinguish price changes arising from changes in product supplies and demands from changes arising from general inflation. Because prices constitute a market economy's fundamental means of conveying information, the increased noise associated with high inflation erodes the effectiveness of the market system. High inflation also complicates long-term economic planning, creating incentives for households and firms to shorten their horizons and to spend resources in managing inflation risk rather than focusing on the most productive activities.

More recently, the evidence has mounted not only that low and stable inflation is beneficial for growth and employment in the long-term but also that it contributes importantly to greater stability of output and employment in the short to medium term. Specifically, during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased--a phenomenon known to economists as the Great Moderation (Bernanke, 2004). This finding challenges some conventional economic views, according to which greater stability of inflation can be achieved only by allowing greater fluctuations in output and employment. The key to explaining why price stability promotes stability in both output and employment is the realization that, when inflation itself is well-controlled, then the public's expectations of inflation will also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low even as it retains substantial freedom to respond to disturbances to the broader economy.

Given the spectacular (and going to be even more spectacular) debt levels of most western nations, it would be interesting to see how things turn out over the next few years. Paraphrasing Hamlet, to print, or not to print, that is the question.