The prices of goods and services are the main drivers of supply and demand in the economy. But the inverse is also true. Changes in supply and demand impact the price of goods and services.
The link between aggregate demand and general price levels is not necessarily clear or direct. However, in the most general sense (and under ceteris paribus conditions), an increase in aggregate demand corresponds with an increase in the price level.
This article examines the relationship between these two phenomena.
Key Takeaways
- The link between aggregate demand and general price levels is not necessarily clear or direct.
- A price level is the average of current prices across the range of goods and services produced in the economy.
- Aggregate demand is a measurement of the total demand for all of the finished goods and services in an economy.
- An increase in aggregate demand generally corresponds with an increase in the price level while a decrease corresponds with a lower price level.
- Even though it's a given that whenever consumers demandmore goods or services, the prices for those goods or services go higher than normal, this does not mean that real prices have to rise.
What Is Aggregate Demand?
Aggregate demand is a measurement of the total demand for all of the finished goods and services in an economy. This measurement is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.
Over the long term, aggregate demand is equivalent to gross domestic product (GDP). The two metrics are calculated the same way:
Total Consumption Spending + Investments + Government Spending + Net Exports.
Aggregate demand increases when its components, including consumption spending, investment spending, government spending, and spending on exports minus imports, rise.
Conversely, a decrease in aggregate demand corresponds with a lower price level. A decrease in aggregate demand occurs when the components of aggregate demand fall.
Ceteris paribus conditions refer to a dominant assumption in mainstream economic thinking. According to this assumption, all other variables remain the same when studying the effect of one economic variable on another. From a theoretical perspective, this makes it possible for economists to isolate particular events that occur within the economy and attempt to study their impacts.
What Is Price Level?
A price level is the average of the current prices of the entire range of goods and services produced in the economy. Price levels are among the most-watchedeconomic indicatorsin the world.
This is because most economists agree that prices should stay relatively stable on a year-over-year (YOY) basis in order to prevent high levels of inflation.
Most price level estimates are calculated by tracking a set basket of goods and services. Using this approach, a collection of consumer-based goods and services is examined in the aggregate, making it possible to identify changes in the broad price level over time. Inflation is the term used to describe rising prices. Deflation describes falling prices.
Purchasing Power
Price level is also related to the purchasing power of consumers. In general, the higher theprice level, the lower thepurchasing powerof money. Purchasing power refers to how much of an item a unit of money can buy. Put simply, it indicates how far one dollar will go.
Purchasing power goes down when prices rise because a single unit of currency can't acquire the same amount as it once could. The converse is true when prices go down; purchasing power increases.
For this reason, the real price level, which compares the prices of goods and services against the purchasing power of money, is particularly useful.
General price levels are purely hypothetical as there is no uniform price for the many goods and services in the economy.
Relationship Between Demand and Prices
The price of a good or service generally has an impact on consumer demand. This is the basis for the law of demand, which states that any increase in prices tends to cause the demand for a good or service to decline.
But macroeconomists normally consider rising nominal prices as crucial for long-term economic demand. The nominal priceof a good is its dollar (or other currency) value.
So why is there no clear, direct link between aggregate demand and general price levels? Even though it's a given that whenever a group of consumers demandsmore goods or services, the prices for those goods or services go higher than normal, this does not mean that real prices have to rise.
Nominal and Real Prices
Nominal prices can be compared to real prices. The real (or relative) price of a good is the good's value expressed in terms of some other good, service, or basket of goods. It's often used to compare one good to a group of goods across different time periods, say from one year to the next year.
It's also true that it can be difficult for economists to determine if prices cause movement along a demand curve or if a shifting demand curve causes price movement.
For example, even though the demand for high-definition televisions is higher than it's been in the past, the real cost of HDTVs has declined. If real prices were to decline even further, demand would likely increase. In other words, more people would be willing to buy $100 televisions than $1,000 televisions.
What Is the Law of Supply and Demand?
The law of supply and demand is an economic theory. It explains how prices affect supply and demand. When prices increase, supplies do as well, lowering demand. When prices drop, demand increases, which leads to a lower inventory or supply of goods and services.
What Does Aggregate Demand Mean?
Aggregate demand is an economic term that is used to describe the total demand for all finished goods and services in the economy. It is typically expressed as the amount of money used to buy those goods and services at certain prices and during a certain period of time.
What Is Purchasing Power?
Purchasing power refers to how much of a good or service one unit of currency will buy. It generally increases when prices go down and drops when prices rise. Purchasing power erodes over time due to inflation. This means that one unit of currency in 1980 probably bought more goods and services than it does today.
The Bottom Line
There is a relationship between aggregate demand and price levels. But what that relationship is remains unclear. One important thing to remember is that prices increase when the demand for goods and services rises. But it may not necessarily be reflected in the real prices of goods and services. In fact, real prices don't even have to rise.
