Prices serve as a crucial indicator of economic trends, significantly impacting a country’s economic stability and its citizens’ quality of life. This article explores why prices matter, how to measure them, and the importance of price stability.
Why Prices Matter and How They Are Calculated
Articles about prices are among the most common economic news stories encountered. Fluctuations in prices are an economic phenomenon that directly affects us personally. Just typing the word ‘prices’ into a search engine brings up a flood of related articles. Most articles about prices carry a tone of concern. They often say things like: “Prices hit their highest level in years,” “Prices rose as international oil prices increased,” or “Grocery shopping became daunting as basket prices surged.”
So why is it a problem when prices rise? To understand inflation simply, it can be described as ‘the average price level of various goods and services’. So why don’t we examine price fluctuations for specific items like ketchup or squid? Why go to the trouble of calculating price changes for countless goods under the umbrella term “inflation”? Combining the fluctuating prices of diverse goods into a single average could yield results detached from reality.
The Reason for Tracking Prices
Considering the purpose reveals why we calculate prices. The government measures and publishes monthly prices to grasp the overall trend in commodity prices. Understanding whether prices for goods and services are generally rising or falling allows for appropriate responses (such as formulating economic policies). Since the goal of measuring prices is to grasp the larger trend, examining price fluctuations for just a few items won’t reveal the main current.
Another reason prices are measured using averages is that the purchasing cycles for different goods vary significantly. For example, food ingredients, meals, clothing, transportation, and gasoline are items consumed frequently in daily life. In contrast, goods like automobiles, TVs, refrigerators, and washing machines are purchased every few years, or even as infrequently as once every decade or so. Because the consumption cycles for different goods vary so greatly, it is difficult to gauge inflation based on just a few items. Therefore, representative items are selected from as many goods as possible, and inflation is calculated by assigning weights based on the average amount people spend on those goods and services. First, representative items are selected from goods and services with high consumer demand. Then, the calculation ensures that items and services consumed more frequently and in larger quantities have a greater impact on the price index.
For example, the price indices published by the Korean government vary in type, depending on which goods and services’ price fluctuations they primarily track. The criteria also differ based on factors like who is most affected by changes in that particular price index. Representative examples include the ‘Producer Price Index’ (PPI), based on the prices producers charge for goods and services; the ‘Wholesale Price Index’ (WPI), based on the selling prices of primary wholesalers; and the ‘Consumer Price Index’ (CPI), based on the prices consumers pay when purchasing goods.
Among the various price indices, the Consumer Price Index is the most familiar and directly relevant statistic for the general public. The Consumer Price Index is published monthly by Statistics Korea and is compiled based on price changes for goods and services included in the 458 representative items selected by Statistics Korea. The current 458 items forming the basis of the Consumer Price Index were finalized at the end of 2020. The representative items are revised every five years to align with changing times. This is because consumer preferences and trends evolve over time. Reflecting this, new goods need to be added to the representative items, while others must be excluded. Examining the representative items that make up the CPI provides a clear picture of how consumption trends in Korean society are shifting and how the average Korean’s consumption patterns have changed.
The Consumer Price Index revises its representative items every five years to reflect changes in consumption patterns over time. In the 2020 revision, the number of representative items was adjusted from 460 in 2015 to 458. Fifteen new items were added in the 2020 revision, including electric vehicles, masks, and clothes dryers, while seventeen items were removed, such as neckties, briquettes, and printers. The current CPI is based on the 2020 price level. That is, prices in 2020 are set as 100 points to track price fluctuations.
The Korea National Statistical Office releases several price indices monthly in addition to the CPI. For example, the Living Expenses Price Index consists of 144 items frequently purchased by consumers and accounting for a large share of spending, while the Fresh Food Price Index comprises only 50 fresh food items like vegetables, fruits, and fish.
Why is price stability important?
Stabilizing prices is essential for the stable development of a national economy. Looking back at history, nations entering periods of decline commonly experienced sharp price surges. Going far back, prices soared during the late Roman Empire. Even in relatively recent history, Germany saw prices skyrocket to murderous levels after World War I. The phenomenon where prices rise steadily overall due to an increase in the money supply is called inflation. The inflation experienced by Germans in 1923 was so extreme that it earned the prefix ‘hyper,’ meaning ‘excessive or extreme,’ becoming known as ‘hyperinflation.’ In other words, it was ‘super-inflation.’
The severity of Germany’s price surge at the time can be gauged simply by examining the fluctuation in the price of bread, a staple food. The price of a loaf of bread, which was 0.5 marks in 1918, skyrocketed to a staggering 1 trillion marks just five years later in 1923. The exchange rate soared to 4 trillion marks per dollar. The value of money had fallen below the worth of the paper used to print the banknotes. This extreme economic instability became the backdrop for the subsequent rise of the totalitarian Nazi regime.
Such hyperinflation is not something confined to history books. More recently, Venezuela in South America has suffered from severe inflation. The IMF (International Monetary Fund) reported Venezuela’s 2017 inflation rate at a staggering 4,300%. This means prices jumped 43 times in just one year. In 2015, it was 112%, and in 2016, 2,800% – rising uncontrollably over time. However, even the 2017 rate seems relatively manageable compared to 2018. In 2018, prices soared by 1,690,000%.
As prices skyrocketed, Venezuelans’ lives plunged into misery. The average monthly salary became insufficient to buy even a single egg. The price surge has left them unable to afford even basic sustenance. According to data released by the UN Refugee Agency (UNHCR) in November 2018, 3 million Venezuelans have left the country since 2015 to migrate to other nations. This means one in ten Venezuelans now finds themselves displaced abroad.
Why did Venezuela’s economy collapse to this extent? Venezuela was once an oil-producing nation boasting vast oil reserves. The Venezuelan government used the money earned from oil exports to provide various welfare benefits to its citizens. However, starting in 2014, as crude oil prices plummeted, the Venezuelan economy, which had no reliable source of income besides oil exports, rapidly collapsed. A major cause of the collapse is widely seen as the government’s failure to adjust welfare policies introduced during the high-oil-price era, despite clearly anticipating the oil price crash. It is reported that Venezuelans lost an average of about 10kg in body weight during the year 2017 alone.
Without economic stability and prosperity, citizens cannot lead happy lives. This historical lesson is why governments worldwide prioritize price stability. The Bank of Korea, Korea’s central bank, was established with price stability as its guiding principle. Visiting the Bank of Korea’s website confirms its founding purpose: “The Bank of Korea contributes to the sound development of the national economy by promoting price stability.”
So why is the fluctuation of prices so crucial to the economy? The reason stabilizing prices is vital is that price stability directly stabilizes the value of the money we use. When prices rise, we must pay more money to buy the same goods. This means the value of money has decreased. Conversely, when prices fall, we can buy the same goods with less money. This means the value of money has increased. For the economy to grow steadily, the belief that money maintains a consistent value must be firmly established among the members of the community.
Let’s explore this in more detail. When prices rise excessively, the distribution of wealth and income within a society becomes unequal. Rising prices make it much easier for the wealthy, who already possess significant assets, to increase their wealth. When prices rise, the quantity of goods and services one can purchase with the same amount of money decreases. For most workers living on fixed monthly salaries, this effectively means their income shrinks. Pensioners living off retirement funds also see their income decrease when prices rise. People who have saved money in banks also suffer losses because the value of their money has fallen. For those who haven’t yet purchased a home, rising prices fueling higher housing costs push the dream of homeownership further out of reach.
While most workers see their real income shrink due to inflation, the wealthy, who already hold significant assets, gain opportunities to profit. Especially those wealthy individuals who owned substantial real estate, such as buildings, houses, or land, become even wealthier as the value of their real estate rises steeply alongside inflation. Thus, excessive inflation creates an unequal distribution of wealth and encourages speculation in real assets like real estate.
When prices rise, consumption increases and savings decrease within the national economy. This is because people judge that spending money now is economically more beneficial than depositing it in a bank, as the value of their money diminishes over time. As savings decline, it becomes harder for companies to secure funds through banks, which soon leads to a slowdown in economic growth. If inflation persists, the real value of workers’ wages declines while real estate prices surge significantly. This creates a strong sense of deprivation for most people and dampens their motivation to work. This briefly summarizes the negative effects of inflation as described in economics.
So, conversely, what happens if prices fall? Does falling inflation have no negative impact on the economy? No, it does. If prices keep falling, consumers will delay spending until prices drop further. Why buy something now at a higher price when it will cost less later? Ultimately, consumption within the national economy continues to shrink. As consumption declines, corporate sales and profits decrease, leading to reduced production activities and investment. Consequently, more businesses fail and jobs disappear.
Even if companies sell the same volume of goods and services, their revenue inevitably decreases because prices have fallen due to inflation, putting them in an increasingly difficult position. Earlier, we said that falling prices mean the value of money has risen. This same principle applies to the debt held by companies and households. While the prices of real assets have fallen, the debt, expressed as a number, remains the same. This effectively means the amount of debt has increased. For example, previously, selling a home might have paid off all the debt, but now, due to falling prices, selling the house might not cover the debt. This increases the burden on the borrower and inevitably leads to greater profits for the lender. Ultimately, steady, gradual price increases that avoid large fluctuations are beneficial for everyone.
