A persistent, broadly-based increase in the prices of consumer goods and services over a protracted period (inflation) leads to a decline in purchasing power.
A persistent, broadly-based increase in the prices of consumer goods and services over a protracted period (inflation) leads to a decline in purchasing power. This can lead to a spiral of rising prices, thereby making it more difficult for consumers and for businesses to plan savings and investments. People may lose confidence in the currency as it is losing value rapidly.
On the other hand, deflation, i.e. an ongoing and widespread fall in prices across the economy that is not due to improvements in production can also have negative repercussions. This is because it can lead to a spiral of falling prices.
For instance, consumption can be systematically postponed in anticipation of lower prices in the future. Businesses will start facing problems as they cannot sell their products. They might need to reduce or freeze wages or even cut staff numbers as demand falls, leading to a rise in unemployment. The economy will start slowing down as consumers and businesses cut back on spending and investing.
The same goes for public finances. Tax revenues decline as incomes and spending decrease, but government debt will still have to be paid. As a result, public spending on infrastructure and healthcare, for example, might need to be reduced. The negative consequences of deflation are therefore felt by everyone.
In conclusion, protracted periods of high inflation or deflation have adverse effects on the economy.
Keeping prices stable is the contribution central banks can make to improving people’s individual welfare, which is why Treaty on the Functioning of the European Union set it as the ECB’s primary objective. This objective reflects lessons learned from history and a broad consensus that, by maintaining price stability, monetary policy contributes significantly to sustainable growth, economic welfare and job creation.