Price stability supports higher living standards by helping to reduce uncertainty about general price developments and thereby improve the transparency of relative prices

First, price stability makes it easier for people to identify changes in the prices of goods expressed in terms of other goods (i.e. “relative prices”), since such changes are not concealed by fluctuations in the overall price level. For example, let us suppose that the price of a certain product increases by 3 %. If the general price level is stable, consumers know that the relative price of this product has increased and may therefore decide to buy less of it. If there is high and unstable inflation, however, it is more difficult to find out the relative price, which may have even declined. In such a situation it may be better for the consumer to buy relatively more of the product of which the price has increased by “only” 3 %. In the case of general deflation, consumers may not be aware of the fact that a fall in the price level of a single product merely reflects general price developments and not a fall in the relative price level of this good. As a result, they may mistakenly buy too much of this product.

Consequently, if prices are stable, firms and consumers do not run the risk of misinterpreting changes in the general price level as relative price changes and can make better informed consumption and investment decisions.

Uncertainty about the rate of inflation may also lead firms to make wrong employment decisions. To illustrate this, let us suppose that in an environment of high inflation, a firm misinterprets the increase in the market price of its goods by, say, 5 %, as a relative price decrease as it is not aware that the inflation rate has recently fallen from, say, 6% to 4%. The firm might then decide to invest less and lay

off workers in order to reduce its production capacities, as it would otherwise expect to make a loss given the perceived decrease in the relative price of its goods. However, this decision would ultimately turn out to be wrong, as the nominal wages of employees due to lower inflation may increase by less than that assumed by the firm. Economists would describe this as a “misallocation” of resources. In essence, it implies that resources have been wasted, as some employees would have been made redundant because of instabilities in price developments.

Price stability reduces inflation uncertainty and therefore helps to prevent the misallocation of resources described above. By helping the market guide resources to where they can be used most productively, lasting price stability increases the efficiency of the economy and, therefore, the welfare of households.