The prices of goods and services are the main driver of supply and demand in the economy. The inverse is also true, though: 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.

Aggregate demand increases when the components of aggregate demand–including consumption spending, investment spending, government spending, and spending on exports minus imports–rise.

Key Takeaways

  • The link between aggregate demand and general price levels is not necessarily clear or direct.
  • Price level is the average of current prices across the entire spectrum of goods and services produced in the economy.
  • Aggregate demand is an economic measurement of the total quantity of finished goods and services that are demanded in an economy; components of aggregate demand include consumption spending, investment spending, government spending, and spending on exports minus imports
  • In the most general sense (and assuming ceteris paribus conditions), an increase in aggregate demand corresponds with an increase in the price level; conversely, a decrease in aggregate demand corresponds with a lower price level.
  • Even though it's a given that whenever a group of consumers demands more goods or services, the prices for those goods or services go higher than normal, this does not mean that real prices (as opposed to nominal prices) have to 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.

Aggregate Demand

Aggregate demand is an economic measurement of the total quantity of finished goods and services that are demanded 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.

Price Level

Price level is the average of current prices across the entire spectrum of goods and services produced in the economy. Of course, the general price level is purely hypothetical; there is obviously no uniform price for the many types of goods and services in the economy.

Price levels are one of the most-watched economic indicators in the world. This is because most economists agree that prices should stay relatively stable year-over-year 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 aggregate; this makes it possible to identify changes in the broad price level over time. When prices rise, this is referred to as inflation. When prices fall, this is referred to as deflation.

The price level is also related to the purchasing power of consumers. In general, the higher the price level, the lower the purchasing power of money. This is because purchasing power refers to how much money can buy. When prices go up, buying power goes down because a single unit of currency–for example, one dollar–can no longer acquire the same amount of goods and services as it once could.

For this reason, the real price level is particularly useful because it compares the prices of goods and services against the purchasing power of money.

Relationship Between Prices and Consumer Demand

In general, when the price of a good or service changes, consumer demand for that good or service is also impacted. 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.

However, macroeconomists normally consider rising nominal prices as crucial for economic demand in the long-term. The nominal price of a good is its value in terms of money, such as dollars.

The reason it may be said that there is no clear, direct link between aggregate demand and general price levels is that, even though it's a given that whenever a group of consumers demands more 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 prices can be compared to real prices. The real price of a good or service is its value expressed in terms of some other good, service, or bundle of goods. The real price of a good is often used to make comparisons between one good to a group or bundle of goods across different time periods–for example, from one year to the next year.

It's also true that for economists, it can be difficult to determine if prices are causing movement along a demand curve, or if a shifting demand curve is causing price movement.

For example, even though the demand for high-definition televisions (HDTVs) 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.