Price
stability: why is it important for you?
Pupils` information leaflet
Concise price stability guidelines
Pupils' leaflet, © European Central Bank, 2005
Use of the material produced by the Bank of
Finland and the ECB, e.g. photocopying and distribution at schools, is
permitted for educational and non-commercial purposes, provided the source is
mentioned.
ISBN (print) 92-9181-703-1
ISBN (online) 92-9181-704-X
TABLE OF CONTENTS
3. Money makes more sense than swapping things
4. Price stability and the value of your money
5. How price changes are measured?
6. Inflation, deflation and price stability
7. Price stability promotes economic growth and employment…
… by making it easier to compare prices
… by reducing the cost of borrowing money
8. The social aspects of price stability
9. The Eurosystem guardian of price stability
What can you buy for € 10? How about two CD singles, or maybe even a
copy of your favourite magazine every week for a month?
But have you ever thought how this is possible? How come you can
exchange a piece of paper for a product or a service? After all, the banknote
itself actually costs only a few cent to produce.
So why is this piece of paper worth so much? It's simply a matter of
trust. If your best friend borrows € 10 from you, you know that he or she will
pay you back. With a stable currency like the euro, you can also be sure that
you will always be able to buy goods and services that are worth as much as the
value printed on the banknote. However, if your money were to decline
substantially in value, then you would lose confidence in it. Money is valuable
because people trust it.
Let's suppose, for a moment, that money didn't exist. People would have
to buy and sell by bartering. If your baker wanted to get a haircut in exchange
for five loaves of bread, he would first have to find a barber who would be
willing to accept those five loaves of bread in exchange. And if the barber
then wanted a pair of shoes, he would have to find a shoe-shop owner who wanted
to exchange his bread for shoes.
We would all have to find someone who wanted what we had to off errand
was able to offer us what we wanted in return. And even if we did fi nd that
person, we would still have to decide on the right exchange ratio for bread
versus haircuts, haircuts versus shoes, etc.
Money simplifies life in three ways. Firstly, it is a medium of exchange
you no longer have to match needs or demands as in a barter economy.
Secondly, money is a unit of account prices are quoted in monetary units
only, and not in terms of goods or services. And, finally, money is a way
of "storing value" people
can save it so that they can buy things in the future.
Price stability is when your money retains its value over time. This is
important if you want to save your money to buy something later, for example.
Imagine how you would feel if you had saved € 10 to buy two CD singles, only to
find that the price had risen to € 12 when you got to the shop. Then, when you
went back with € 12, the price had gone up to € 14. Fortunately, prices don't
usually rise that quickly (see inflation table on pages 14 and 15).
Consumer price indices which we use to check price stability are
compiled once a month using what is called a "shopping basket". This
basket contains a broad range of products which are typically consumed by a
representative household. The total price of the "shopping basket",
as a measure of the general price level, is then periodically checked to see
how much prices are rising (or, in rare cases, falling).
Inflation is an increase in the general price level. In simple terms,
inflation can arise when there is too much money chasing too few goods. Prices
may increase for different reasons. For example, suppose there is only one CD
left in the shop and you and all your friends want to buy it. The shopkeeper
will probably increase the price of the CD because he knows that demand is high
and he can get more money for it.
Similarly, a product may become more expensive if it costs more to
produce it. If energy prices go up, for example, then the costs of producing
your CD will also go up and the manufacturer will increase its wholesale price
in order to avoid making a loss. For the same reason, the shopkeeper will
attempt to pass this price increase on to you.
In both examples, your € 10 has lost its value, or its "purchasing
power", because it is no longer enough to buy two CD singles. However, we
can only speak of inflation if this were to happen to the total price of the
whole range of products included in the "shopping basket", and not
just to one item. Deflation can be defined as the opposite of inflation, or as
a situation where the general price level falls over time. It may result from
low demand for goods and services, which forces companies to sell their
products at cheaper prices.
Prices are said to be stable if, on average, they neither increase (as
in periods of inflation) nor decrease (as in periods of deflation) over time.
If, for example, € 50 can buy roughly the same "shopping basket" as
it could one or two years previously, then we can say that the general price
level is stable.
Stable prices make it easier to compare prices and therefore to decide
which goods or services to buy.
When prices are stable, you can easily tell if the price of the
trendiest jeans has increased compared with the price of the latest trainers.
This means that you as a consumer can make better decisions on what to buy with
your money. In the same way, companies can make well-informed investment
decisions. Resources can then be allocated in the most productive manner and the productive potential of the economy
will increase.
With inflation (or deflation) the prices of all goods change significantly
and frequently and in an unpredictable manner. As a result, it is difficult to
judge whether the change in the price of a product makes it cheaper or more
expensive in relation to other products. Consequently, companies and consumers
may misinterpret price changes and make mistakes in their purchasing decisions.
This then leads to an unproductive use
of resources.
When prices are stable, savers and lenders are prepared to accept lower
interest rates on their savings because they expect the value of their money to
stay the same over longer periods of time. Otherwise, they would want some
insurance against the uncertainty surrounding the future value of their money
and request a higher rate of interest when depositing or lending it.
As a result, borrowers can benefit from lower interest rates. This means
lower borrowing costs for companies that want to buy more modern machinery and
for people who want a loan in order to buy a car or a house, for example.
Encouraging companies to invest in this way helps to improve their
competitiveness and creates extra jobs. This is another reason why stable
prices are such an important contribution to economic growth and employment.
Price stability is key to social stability, too. In an inflationary
environment prices tend to change in an unpredictable way, which may cause
considerable losses to people. For example, inflation can reduce the value of
people`s savings. Typically, the poorest groups of society often suffer the
most from inflation, as they have only limited possibilities to protect
themselves. Throughout history, high rates of inflation (or deflation) have
often created social instability.
The European Central Bank and the national central banks of the euro
area together make up the Eurosystem, the central banking system of the euro
area (see map). The main objective of the Eurosystem is to keep prices stable
for the euro area as a whole. The monetary policy of the ECB aims to maintain
the annual euro area inflation rate at a very low level, i. e. below but close
to 2 % over the medium term. In other words, your two CD singles should cost
much the same in the future as they do now (see inflation table on pages 14 and
15).
Barter: the mutual exchange of goods and services without
using money as a medium of exchange. It can only take place when there is a
mutual need for the items being traded.
Consumer Price
Index: compiled once a month using
what is called a "shopping basket". For the euro area, the Harmonised
Index of Consumer Prices (HICP) is used, with a statistical methodology that
has been harmonised across countries.
Deflation: a decline in the general price level, e. g. in the
consumer price index.
Euro area: the area that is made up of those Member States of
the European Union in which the euro has been adopted as the single currency.
European Central
Bank (ECB): established on 1 June 1998
and located in
European System of
Central Banks (ESCB): the ECB and
the national central banks of all EU
Member States, regardless of whether or not they have adopted the euro.
Eurosystem: the ECB and the national central banks of those
Member States that have already adopted the euro.
Inflation: an increase in the general price level, e. g. in the
consumer price index.
Interest rate: the percentage of extra money you get if you lend
your money to someone else (or keep it in the bank) or the percentage of extra
money you have to pay if you borrow money.
Price stability: maintaining price stability is the primary
objective of the Eurosystem. The
Governing Council of the ECB, the supreme decision-making body of the ECB, has
defined price stability as a year-on-year increase in the HICP for the euro
area of below 2 %. It has further clarified that within this definition it aims
to maintain the annual inflation rate at below but close to 2 % over the medium
term.
1. The impact of inflation on the price of two CD
singles costing € 10 today (after n years)
Annual
inflation rate: 1% 2% 5%
10% 30%
Stable
prices Inflationary environment
1 year
later 10,10 10,20 10,50 11,00
13,00
2 years later 10,20 10,40 11,03 12,10 16,90
3 years later 10,30 10,61 11,58 13,31 21,97
4 years later 10,41 10,82 12,16 14,64 28,56
5 years later 10,51 11,04 12,76 16,11 37,13
6 years later 10,62 11,26 13,40 17,72
48,27
7 years later 10,72 11,49 14,07 19,49 62,75
8 years later 10,83 11,72 14,77 21,44 81,57
9 years later 10,94 11,95 15,51 23,58 106,04
10 years later 11,05 12,19 16,29 25,94 137,86
2. The
impact of inflation on the purchasing power of money (base year = 100, after n
years at a given inflation rate, as a percentage)
Annual
inflation rate: 1 % 2 % 5 % 10 % 30 %
Stable
prices Inflationary environment
1 year
later 99,0 98,0 95,2 90,9 76,9
2 years later 98,0 96,1 90,7 82,6 59,2
3 years later 97,1 94,2 86,4 75,1 45,5
4 years later 96,1 92,4 82,3 68,3 35,0
5 years later 95,1 90,6 78,4 62,1 26,9
6 years later 94,2 88,8 74,6 56,4 20,7
7 years later 93,3 87,1 71,1 51,3 15,9
8 years later 92,3 85,3 67,7 46,7 12,3
9 years later 91,4 83,7 64,5 42,4
9,4
10 years later 90,5 82,0 61,4 38,6 7,3