Price Level

Updated on April 10, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Price Level?

The price level is the mean price of all the goods & services currently produced and getting sold in the market of a country. Therefore, it is an important tool for economists to measure and monitor any changes in the price levels of goods & services along with purchase power in an economy.

Price Level

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The consumer price index (CPI) has been the most fundamental unit to measure price level. It changes with the change in the level of inflation and deflation. The price level helps to assess purchasing power and serves to make the supply chain more efficient. It is expressed in dollars or smaller discrete values. In the securities market, it refers to the asset’s price being traded.

Key Takeaways

  • The price level is the mean price of all products and services produced in an economy of a country in its market or category.
  • It is a very good indicator of the purchasing power in an economy, and it changes with inflation or deflation.
  • It helps economists measure and monitor any changes in the price levels of goods & services in an economy and thus understand the predominant current economic trends.
  • The basic formula to determine price level has been money supply & velocity of money divided by final output.

Price Level In Economics Explained

Price level tends to be a metric of the overall degree of prices at a specific point in time as assessed by the CPI. In economics, it can be explained as measuring the existing price of products and services getting produced in a particular nation, region, or area of an economy. The aggregate price level also gets understood as the weighted arithmetic average of existing prices of total goods plus services. One may consider this to be a certain average of related prices that have been broadly classified into commodity groups.

The Bureau of Labor Statistics publishes consumer price levels and the producer price index. When one chooses a particular type of commodity while considering the related steps pertaining to the distribution channel, they obtain the below levels:

  • Consumer
  • Wholesale
  • Product

One can also deduce these indicators using the deflators technique. It gets computed as a ratio of current price values to constant price values of the common aggregate. In such a case, one gets the following:

  • GDP deflator
  • Investment deflator
  • Consumption deflator
  • Public expenditure deflator

Moreover, assets such as securities and real estate never get included in traditional definitions of the price level. Hence, any increase or decrease in the securities exchange price index never gets called inflation or deflation. The rate of inflation means the change in this level on an annual percentage basis. Any change in relative price may not mean inflation. Likewise, higher inflation may not affect the relative prices.

One could also understand this as a percentage rate of change occurring to the price level. The level is measured using the price index. A price index can be defined as a metric whose movement represents the price level changes. If it rises, then the level also rises, and vice versa.

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Price Level Formula

One could use the quantity theory of money to calculate the price level. The formula of the quantity theory of price is as follows:

P = (M-V)/Y

Where:

  • P = price level.
  • Y = final output.
  • M = money supply
  • V = velocity of money

For the classical economic model, the money supply has been an exogenous variable making the money supply nM growth rate also exogenous. Furthermore, the velocity of money has also been considered exogenous, so M-V also becomes exogenous.

One should recall that the labor market, along with the production function, determines the final output Y . Therefore, when one combines the final output with the quantity theory of money, one can deduce the price level P as shown above equation. Let us assume that a nation’s GDP remains constant during a period. In this circumstance, V also remains constant, so the percentage change in the level would equal the percentage change of M.

As we removed the trend from the final output, Y keeps cycling over some mean during that period. Moreover, the final output neither remains constant nor shows any growth. Hence, here n=nM would still hold even though Y remains variable. Therefore, the trend of the final output had to be removed. Otherwise, inflation would tend to be equal to the money supply growth minus GDP’s real growth.

Calculation

The price index can also be calculated using the price level formula in the following steps:

  • Selection of goods and service types for inclusion in the list that, together with their quantity, gets termed as the market basket of an index.
  • Determining the base period for buying the market basket usually comes out to be one year.
  • Computing the total price of the market basket in the selected base period
  • Finally, calculating the price index, which equals the existing price divided by the base minus the cost of the market basket in the selected period. Or

Price index=current cost of basket/base−period cost of the market basket

However, consumer price index (CPI) instead of price index has been most commonly used in equations:

CPIt= [ Cost of basket in year t/Cost of basket base year] ×100

As the CPI changes, the general price level also changes.

Examples

Let us look at a couple of examples to understand the concept clearly.

Example # 1

Let us look at the price data for different commodities:

ProductBase year quantityBase year price (2) (in $)Base year expenditure (1)*(2)(in $)Current year price (in $)Current year expenditure (in $)
coffee101212013130
Flour51155450
Coke20360462
   235 242
  • Current year CPI = 242/235*100 = 102.97
  • Percentage change in CPI = [102.97-100/100] = 2.97%
  • It means the rate of inflation = 2.97%

Therefore the price level of goods & prices has increased at the rate of 2.97%.

Example # 2

According to a report by pricing firms Argus Media and S&P Global Platts, Russia’s Ural crude has exceeded its G7-priced $60 per barrel price cap. Reports also suggest that this breach of the price level, which was initially set up to control the oil exports, might be muted on the supplies to India. A sustained narrowing of the gap between the prices of Urals and other crude oil grades and benchmarks could eventually dull the appeal of Russian oil for India.

Price Level vs Inflation

Let us go through the table below to understand the difference between the two:

Price LevelInflation Rate
It tells the level of price rise of goods and services.The inflation rate tells the speed with which the price of goods will rise.
If it rises, then inflation has positive values.If it rises, it means that the price level gets increases rapidly.
A fall in the level means that inflation has negative values.If it falls, it means that the price rise has slowed down to a great extent.

Frequently Asked Questions (FAQs)

1. What is the effect of an increase in the price level?

Price level signifies the average prices of goods and services produced in an economy. An increase in this level will enhance the money demand, extrapolate interest rates, and reduce investment spending plus consumer spending power.

2. What is the general price level?

The price level is the mean of the current prices of goods and services in an economy. A general price level is the annual average of twelve-month values within the United States consumer price index concerning urban consumers as outlined by the United States labor department. It gives valuable insights into the purchasing power of the general population and hence the current economic trends.

3. What is the effect of a decrease in the price level?

A decrease in the price level will lead to reduced money demand from businesses and consumers. As a result, the interest rate would also fall, borrowing would increase, and consumption and investment would increase.

This has been a guide to what is Price Level. Here, we explain its formula, how to calculate it along with its examples and comparison with inflation. You can learn more about it from the following articles –

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