Question

1. Explain the concept of the price level, how it is measured, and how it relates to aggregate demand
2. Considering aggregate demand, what is the relationship between total spending and the price level?

Answer 1

The price level is the average of prices of all the goods and services in a country. The most commonly used price index is the Consumer price index. The consumer price index is the weighted average of the changes in the price level of the basket of goods and services in a country. It is given by the following formula:

CPI = (cost of the market basket in the given year/cost of the market basket in the base year) *100

Here, the base year is a year chosen as a reference point for the price change in a given year.

Price level varies inversely with the aggregate demand. Aggregate demand is the sum of all goods and services demanded at a given price level. It is the sum of consumption spending, investment spending, government spending, and net exports. As the price level increases in the economy, aggregate demand decreases, and vice versa. An increase in the price level means greater inflation, at high inflation general price level increases in the economy which reduces the aggregate demand.

Aggregate demand is the sum of consumption spending, investment spending, government spending, and net exports. Thus, total spending is the same as aggregate demand and it varies inversely with the price level.