Price level

Price level

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A price level is a hypothetical measure of overall price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...

s for some set of goods and services, in a given region during a given interval, normalized relative to some base set. Typically, a price level is approximated with a price index
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

.

Theoretical foundation


The classical dichotomy
Classical dichotomy
In macroeconomics, the classical dichotomy refers to an idea attributed to classical and pre-Keynesian economics that real and nominal variables can be analyzed separately...

 is the assumption that there is a relatively clean distinction between overall increases or decreases in prices and underlying, “nominal” economic variables. Thus, if prices overall increase or decrease, it is assumed that this change can be decomposed as follows:

Given a set of goods and services, the total value of transactions in at time is
where represents the quantity of at time represents the prevailing price of at time represents the “real” price of at time is the price level at time

A price level is distinguished from a price index in that the existence of the former depends upon the classical dichotomy, while the latter is simply a computation, and many such will be possible regardless of whether they are meaningful.

Significance


If, indeed, a price-level component could be distinguished, then it would be possible to measure the difference in overall prices between two regions or intervals. For example, the inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 rate could be measured as
and “real” economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

 or contraction could be distinguished from mere price changes by deflating
GDP deflator
In economics, the GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy...

 GDP or some other measure.

See also

  • Price index
    Price index
    A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...

  • Equation of exchange
    Equation of exchange
    In economics, the equation of exchange is the relation:M\cdot V = P\cdot Qwhere, for a given period,M\, is the total nominal amount of money in circulation on average in an economy.V\, is the velocity of money, that is the average frequency with which a unit of money is spent.P\, is the price...

  • Quantity theory of money
    Quantity theory of money
    In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....

  • Wage level