Tuesday, 29 May 2012

'Price stability'

'Price stability'

When we discuss, write about, talk about or analyse this monetary item described above, we call it money and describe it using the term money with the implicit assumption that this money we are dealing with is stable – as in fixed – in real economic value in our low inflationary economies. We thus assume at the same time that prices are more or less stable in low inflationary economies too.

The term stable is generally accepted by the public at large to indicate a permanently fixed situation or position or state or price or value. A stable – as in fixed – price over time would be represented as a horizontal line on a chart.  A slowly increasing price over time would be drawn as a slightly rising line on a chart. A slowly decreasing value over time would be drawn as a slightly declining line on a chart. When we say production of a commodity is stable we accept that the absolute number of items being produced is not fluctuating but is the same all the time.

The term ‘price stability’ as used by economists, however, does not mean a fixed price or level, even though that is what the public in general thinks it means. The term stable in economics today means slowly increasing or slowly decreasing – depending on what it is being applied to. The term price stability as used by economists today does not mean that prices in general stay the same, but that prices in general are rising slowly, which is, as we are all taught, the popular definition of inflation.

The term stable money as used by economists equally does not mean that the real value of national monetary units they are talking about stays the same in the internal economy – even though that is what the public in general thinks it means. What they mean with stable money is that the real value of a national monetary unit is slowly being eroded by inflation over time in the internal economy.

When a central bank governor says that the central bank’s primary task or objective is price stability what she or he means is that the central bank would be fulfilling its primary task, in an economy with low levels of inflation, when prices in general are slowly rising over time, that well known definition of inflation again. The flip side of that statement is that the real value of national monetary units is slowly being eroded by inflation over time.

A central bank’s primary task being price stability is the same as saying a central bank’s main responsibility is ensuring that inflation is maintained at a very low level. This low level was generally accepted in first world economies to be two per cent per annum. The sub–prime mortgage crisis (2008) raised doubts about the two per cent level being sufficient in the event of large shocks to the economy.

‘In a world of small shocks, 2 per cent inflation seemed to provide a sufficient cushion to make the zero lower bound unimportant.’

‘Should policymakers therefore aim for a higher target inflation rate in normal times,

in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 per cent than at 2 per cent, the current target range?’ 

(Blanchard, Dell´Ariccia and Mauro, 2010:  4 and 11)

The maintenance of a high degree of price stability generally (still) means that the primary task of a central bank in a first world economy is to limit the erosion of real value in money and other monetary items by inflation to a maximum of two per cent per annum within an economy or monetary union. Continuous two per cent annual inflation erodes two per cent of the real value of money and other monetary items per annum; i.e., 51 per cent over 35 years. Under the current Historical Cost paradigm it also means that the implementation of the very erosive stable measuring unit assumption as it forms part of the traditional HCA model unknowingly, unintentionally and unnecessarily erodes two per cent per annum of the real value of constant real value non–monetary items never maintained constant. This erosion by the HCA model is eliminated completely when it is freely chosen to measure financial capital maintenance in units of constant purchasing power during inflation (CIPPA).

Nicolaas Smith

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