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Price Stability and the Optimal Rate of Inflation

            The European Central Bank cites its 'primary objective' of monetary policy is to 'maintain price stability ' (ECB website). The pursuit of price stability is important to this major economic power and theoretical and empirical evidence fully supports the view. Price stability is regarded as the absence of any persistent and pronounced rise or fall of prices thus the objective is to keep inflation at a low stable level (Cecchetti, 2011). It is important to note, especially in recent years, this also includes avoiding deflation as well. This paper discusses the economic and social costs associated with inflation and deflation to highlight the importance of a price stability mandate. Any unanticipated inflation, distorts information in the marketplace, preventing economic agents from making well-informed decisions. When there is variable inflation, changes in relative prices are compounded with rising price levels and obtaining accurate information is difficult and costly to acquire (Caraballo, 2012). Further, there is confusion and uncertainty about future prices that make planning and investment problematic. Thus empirical evidence supports that inflation reduces real economic growth by reducing investment and the rate of productivity growth (Fischer, 1993; Briault, 1995). It is also important to note that both inflation and deflation lead to the arbitrary redistribution of wealth by undermining the use of money as a unit of account. .
             Inflation has the ability to distort information in the market, namely relative prices. Unanticipated inflation creates misperceptions within individual markets that lead to increased prices. An increasing price level creates the illusion that there is increased demand within an individual market, thus agents will distribute greater resources to that market resulting in increased prices that then cause actual change in relative prices.

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