For most economists the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.
According to this way of thinking, a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services, and enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services. Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.
The Rationale for Price-Stabilization Policies
For instance, let us say that demand increases for potatoes versus tomatoes. This relative strengthening, it is held, is going to be depicted by a greater increase in the price of potatoes than for tomatoes.
Now in an unhampered market, businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence in our example, by paying attention to relative changes in prices, businesses are likely to increase the production of potatoes versus tomatoes.
According to this way of thinking, if the price level is not stable, then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
Thus, it is feared that unstable prices will lead to a misallocation of resources and to the weakening of economic fundamentals. Unstable changes in the price level obscure changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
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