Why price stability?
The Central Bank's main objective is price stability, or in other words, a low and stable rate of inflation. Inflation can be described as a persistent rise in prices. Inflation refers to the average price of goods and services in the market, not the price of an individual good or type of service. A persistent rise in prices refers to a series of rises over a fairly long period, e.g. one year, rather than, for instance, a rise in a single month. Inflation represents a reduction in the value of money, i.e., a smaller volume of goods and services can be obtained for each unit of money.
Changes in prices are measured with indices. The most common measurement of price changes is the Consumer Price Index (CPI). Regular surveys are made of the consumption pattern of Icelandic households. A survey of prices is made each month and the results of the consumption survey provide weightings for individual types of goods and services in a total index. The percentage change in the index over a specified period, such as 12 months, is then used as a measurement of inflation. Negative effects of inflation
High inflation is considered undesirable. Inflation creates uncertainty, especially since the volatility of inflation tends to increase, the higher it is. Such uncertainty entails various costs. Businesses can make incorrect investment decisions. Consumers? awareness of relative price changes becomes blurred when prices are constantly changing, reducing the degree of restraint that competition imposes. It becomes more difficult to distinguish between relative price changes and changes in the general level of prices. A high and variable rate of inflation means that higher interest rates or price indexation need to be offered in order to compensate owners of savings or credit institutions for the decline in real value of their assets and the greater uncertainty on their real rate of return. In the absence of price indexation, higher inflation makes financial institutions more reluctant to provide long-term loans to businesses and households. A high and variable rate of inflation may therefore reduce investment. Thus there are valid grounds for arguing that a high and volatile rate of inflation can result in lower economic growth in the long run. Empirical research confirms these conclusions. Finally, inflation often leads to random, undesirable and unfair transfers of assets between sections of society and generations of the population, for example from owners of savings to debtors. Thus a high and variable rate of inflation can cause long lasting damage to the economy by increasing uncertainty and reducing the effectiveness of market mechanisms. Monetary policy and price stability
On the other hand, the prevailing view among economists is that in the long run, provided that inflation is low and stable, monetary policy only affects nominal aggregates, such as inflation, nominal interest rates and the nominal exchange rate, but not their long-term growth levels in real terms. In the long run monetary policy therefore primarily determines their monetary value, i.e. general prices. Inflation indicates how the monetary value of these assets changes over time, i.e. how the purchasing power of money changes with respect to them. It is in this sense that inflation is said to be a monetary phenomenon.
A well-designed monetary policy can therefore enhance public welfare by ensuring stable prices. By ensuring price stability it can also reduce fluctuation in the real value of aggregates. Excessively accommodative and erratic monetary policy, on the other hand, will exacerbate uncertainty and harm the economy. The contribution that monetary policy can make towards a sound economy is therefore clearly to maintain stable prices.