# Price level

Annual rates of change in prices in Germany since 1965
Price increase in the member states of the European Community (EC) from 1970 to 1980

The price level ( ) is an economic key figure that indicates how many monetary units have to be paid for in an economy for the prices of certain goods and services in a shopping basket . ${\ displaystyle p}$

## General

The economics focuses on comparison and analysis purposes with various statistical data , in the form of curves are combined for a certain period at a fixed data series. This level set includes, among other things, the price level, with which, in particular, price level stability is measured, the domestic production level , the exchange rate level or the interest rate level , which can be visualized using interest curves .

As one of the key economic indicators, the price level is the focus of observation by economic agents ( economic policy , companies , private households , the state , analysts ), since its reciprocal value says something about the purchasing power of a currency . If the price level in the economy rises, purchasing power falls and vice versa. A tendency towards rising price level is called inflation , falling deflation . However, inflation is only spoken of when the price level has risen for 6 months without interruption. Because of its importance for the economy, the price level is an important economic policy goal within the magic square of achieving price level stability at all times , which is even anchored in law ( § 1 Stability Act ).

The changes caused by prices are the reason why a distinction is made in economics and tax law between nominal value and real value . The money retains its printed face value, but with inflation its real value decreases.

## Influencing factors

In the longer term, inflation / deflation is a monetary phenomenon because the price level on the goods market is determined by the money supply in the money market . However, the development of the money supply does not have an immediate effect on the price level. In an empirical study for the period from 1970 to 1990 , the Deutsche Bundesbank came to the conclusion that the price development in Germany follows the money supply development with a time lag. Thereafter, the effect of the change in price level sets in after about 2 ½ years.

In the short term, the price level is also influenced by other factors, such as wage increases ( wage-price spiral , English wage-push inflation ), production cost increases ( English cost-push inflation ), oil price increases ( imported inflation ) or an increase in the value added tax ( English tax -push-inflation ).

## Price level development

A falling price level is known as deflation , a rising price level as inflation . A sharply rising price level is called hyperinflation , a rising price level when economic growth comes to a standstill is called stagflation .

## Relative price level

The relative price level is the relationship between the general consumer price level and the general wage level .

It shows the efficiency of an economy , whereby a lower relative price level means higher efficiency, since in this case less work has to be done for the same goods and services.

In a stagflation, the general consumer price level rises faster than the general wage level, so the relative price level rises. Stagflation thus indicates a loss of economic efficiency.

## Expected price level

The expected price level p e , also called the expected price level , is the price that is assumed for the following period. It is closely related to labor market theories in terms of wage setting, price setting and production expectations.

### Expected price level and wage setting

In economic theory, the expected price level is one of the influencing variables on the level of the nominal wage (w). This is justified by the fact that future prices are viewed by the collective bargaining parties as an important factor influencing the purchasing power of future wages and are therefore taken into account in collective bargaining . The wage setting function is:

${\ displaystyle w = p ^ {e} \ cdot F (u, z)}$

Now if workers expect prices to rise, they will demand a wage increase. For example, if employers expect their payable prices to double, they will be willing to double their nominal wages. In this case, the real wage (w / p) would remain constant, as both factors change in the same way. This means a positive connection between the expected price level and the nominal wage.

### Consideration of the expected price level in the AS-AD model

The expected price level is an important component in the AS-AD model .

#### The aggregated offer

The aggregated supply shows the extent to which changes in production affect the price level. The aggregate supply curve describes a mechanism by which prices and wages adjust over time; H. rise or fall.

In order to examine the mode of operation of p e , the wage setting function (see above) and the price setting function are first combined to form a new equation by eliminating W.

Pricing function: ${\ displaystyle p = (1+ \ mu) \ cdot W}$

Price wage setting equation: ${\ displaystyle p = p ^ {e} \ cdot (1+ \ mu) \ cdot F (u, z)}$

It can be seen that the price level only changes if p e or the unemployment rate u change. If you now replace the unemployment rate , you get the following equation: ${\ displaystyle u = 1-Y / Z}$

AS function: ${\ displaystyle p = p ^ {e} \ cdot (1+ \ mu) \ cdot F (1-Y / L, z)}$

The aggregated supply curve (AS curve)

Basically one can say that in the short term the price level usually corresponds to the price expectation. In the medium term, however, p e will adjust to p.

The AS function says that p is positively dependent on p e and the production level (Y) (assuming short and medium-term constancy of the other variables). So if a higher price level is expected, the actual one adjusts in the same proportion. If a price increase is expected, then the wages adjust positively. If a nominal wage increase takes place in order to achieve the desired real wage, then this increases the costs for the company. The companies will then pass on the increased costs to the prices, which in turn leads to an increase in the price level.

Given the price expectation, increased production would cause prices to rise. This illustrates the rising supply curve. If production corresponds to its natural production level (Y = Y n ), then the price level also corresponds to the expected price level (in A). In conclusion, one can say that strong economic activity causes price pressure. If Y <Y n then p <p e and the curve will shift downwards. If Y> Y n then p> p e and the AS function shifts upwards.

The AS-AD equilibrium is dependent on p e , it determines the position of the aggregated supply curve - if the expected price level increases, the AS curve shifts upwards and vice versa. The equilibrium point A, where Y = Y n and p = p e , shifts analogously.

As long as production is above its natural level, the price level exceeds what is expected. Over time, however, this process will adjust again. Then if Y> Y n , the price expectation will increase and the people involved in the wage setting will adjust the nominal wage accordingly positively. With the increased costs for companies, they will also increase their prices for their goods and services. The real money supply is falling. Now interest rates will rise and production will have to be reduced until production levels return to their natural level. Now Y = Y n then p = p e .

### inflation

In connection with inflation , expected inflation and unemployment, the price-wage setting equation is used and exchanged for a term. From the wage setting formula we replace F (u, z) and assume the following relationship:

${\ displaystyle F (u, z) = (1- \ alpha \ cdot u + z)}$

That means, for example: the wage will be higher, the lower the unemployment rate u is.

The result is the equation:

${\ displaystyle p = p ^ {e} \ cdot (1+ \ mu) \ cdot (1- \ alpha \ cdot u + z)}$

As already described, the increase in the expected price level leads to an increase in the actual price level, as well as a higher nominal wage and a price increase resulting from the increased costs for the company.

Based on a given price level of the previous period, the increase in the price level of the current period nevertheless means an increase in the price increase from the previous period to the current one - i.e. a higher inflation rate.

Given the price level of the previous period, a higher expected price level of the current period leads to a higher expected rate of price increase from the previous period to the current period - higher expected inflation.

The fact that an increase in P e also leads to an increase in the actual price level can equally be applied to inflation: an increase in expected inflation leads to an increase in actual inflation.

### Alternative approach

It is also conceivable that the expected price level p e adapts to p, the actual price level, as described in the following equation.

${\ displaystyle p ^ {e} = p \ cdot [1+ \ lambda (YY ^ {*})]}$

The consequence of this would be that the AS curve would run horizontally in the short term and not increase slightly as in the previous approach. However, this is not a substantial difference.

## Measurement

The general price level is the simple or weighted arithmetic mean of all prices in an economy, so that the resulting amount of data makes its measurement seem insoluble. A measured variable that is as representative as possible must therefore be used. The price level is therefore measured using a shopping basket using a price index . The decisive criterion for the choice of a certain price index is its suitability as a measure of the general price level, whereby no price index is regarded as indisputable as an indicator of the price level. The price index for the cost of living ( Laspeyres index ) and the price index for the national product ( Paasche index ) have emerged, which differ both in terms of the economic sectors covered and in terms of their method of calculation.