We all care about how much the things we buy cost, especially if prices change a lot in a short period of time or in an unpredictable way. Price stability means our money maintaining its value over time; i.e. it ensures that the same quantity of money buys roughly the same amount of goods and services tomorrow as it does today. There are several benefits to this:
- It allows firms and consumers to make better-informed investment and spending decisions, paving the way for a more efficient allocation of resources and increasing the economy’s potential output.
- It reduces the interest rate premium demanded by investors as compensation for the risks associated with holding nominal assets over the long term, with a view to protecting their capital against unexpected inflation. This drives up the incentives for investment.
- In a high inflation environment, households and firms tend to stockpile real goods (which retain their value amid inflation). Price stability reduces the likelihood of households and firms diverting resources to such investments, which are inefficient and stymie economic growth.
- It eliminates the real costs incurred when inflation exacerbates the distortionary effects of tax and social security systems.
- It mitigates the effect that inflation (acting as a tax) has on cash holdings, lowering demand for cash.
- It helps to maintain social cohesion and stability.
The Treaty on the Functioning of the European Union (TFEU) gives the Eurosystem the primary mandate of maintaining price stability. As a result, the European Central Bank (ECB) ensures that the prices of consumer goods and services do not rise or fall sharply over a long period of time, safeguarding the price stability that we need to plan our purchase and investment decisions, and thus foster economic growth in the euro area.
Specifically, the ECB Governing Council considers that the best way to maintain price stability in the euro area is through a medium-term inflation target of 2% (see What is the ECB’s monetary policy strategy?).