How Does Aggregate Demand Affect Price Level?

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.

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.

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-watched economic indicators in 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 the price level, the lower the purchasing power of 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.

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 price of 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 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 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.

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.