Learn the definition of the price level in economics and understand how to calculate it. See the price level equation and find the popular ways to measure it.
Updated: 11/21/2023
Price Level Definition, Equation & Calculation
Table of Contents
- What is Price Level?
- Price Level Changes
- Price Level Measurement
- Price Level Equation
- How to Calculate Price Level
- Price Level Examples
- Lesson Summary
Frequently Asked Questions
What is the difference between price level and inflation?
The main difference between the price level and inflation is that price level is a measurement of the overall prices of goods and services in an economy and the changes in those prices over time. Inflation is a specific economic phenomenon that refers to an increase in the overall prices of goods and services in an economy. Price level changes can be caused by inflation or deflation, but inflation is associated with a rise in the price level.
What does a rise in price level mean?
A rise in the price level means that, on average, prices have increased. This could be caused by inflationary pressures such as an increase in the money supply or an increase in production costs. A rise in the price level can also be caused by a decrease in the value of the currency, which would lead to higher prices for imported goods.
How do you calculate the price level?
There are several ways to calculate the price level, but the most popular method is the Consumer Price Index (CPI). The CPI tracks the prices of a shopping basket of goods and services at a particular time and then calculates the changes in those prices over time. When using CPI to calculate price level changes, a base year is chosen. The current year's CPI is calculated by taking the current year's prices and dividing them by the base year's prices. The result will then be multiplied by 100 to express the CPI as a percentage.
Table of Contents
- What is Price Level?
- Price Level Changes
- Price Level Measurement
- Price Level Equation
- How to Calculate Price Level
- Price Level Examples
- Lesson Summary
The term price level is defined as a measurement of the current prices of goods and services produced in the economy of a specific region or country at a specific time. In other words, it can be considered a measure of the average prices of goods and services in the economy. The price level is important because it can give insights into inflation, a key concern for central banks and policy-makers. Inflation is a measurement that tracks the rate at which prices for goods and services increase over time. Higher price level increases correlate with higher rates of inflation.
There are several ways to measure price level. The most common is the consumer price index (CPI), but it can also be measured with other calculations such as the producer price index (PPI) or the GDP deflator.
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Two large forces change the price level: inflation and deflation. Inflation is a consistent increase in the general price level of services and goods within a specific economy. A period of inflation is typically associated with an increase in the money supply, which results in higher prices for goods and services. The most common measure of inflation is the CPI. Deflation can be thought of as the opposite of inflation. It is defined as a sustained decrease in the general price level of goods and services in an economy that is usually associated with a decrease in the money supply. CPI is also a common measure of deflation.
Inflation and deflation can have a major impact on the economy. For example, inflation can lead to higher interest rates, leading to slower economic growth. Conversely, deflation can also lead to lower interest rates, stimulating economic activity.
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The most common method for measuring aggregate price level is the consumer price index (CPI). The CPI measures the prices of a basket of goods and services typically purchased by households. The basket of goods and services is known as the CPI market basket. The CPI market basket includes food, clothing, shelter, transportation, and medical care. The CPI is released monthly by the Bureau of Labor Statistics in the United States.
Another measure of the price level is the gross domestic product deflator (GDP deflator). The GDP deflator measures the prices of all final goods and services produced within the economy. It is released quarterly by the Bureau of Economic Analysis in the United States.
The producer price index (PPI) is another price level measure. The PPI measures the prices of goods and services at the producer or wholesale level. The PPI is released monthly by the Bureau of Labor Statistics in the United States.
Each of these measures has its specific advantages and disadvantages. The CPI is the most widely used measure of inflation because it is released monthly and includes a wide range of goods and services. However, the CPI does not include prices of investment goods, such as real estate, life insurance, stocks, and bonds. The GDP deflator is considered a comprehensive measure of inflation by some because it includes all final goods and services produced within the economy. However, the GDP deflator is released quarterly, less time than the CPI. Finally, the PPI is useful for measuring inflation at the producer or wholesale level, but it does not include all goods and services produced within the economy.
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The price level equation can provide economists with a way to monitor price changes and how they relate to inflation and deflation. The equation can also be used to calculate the real value of money. For example, if being calculated in terms of CPI, the price level formula can be expressed as:
CPI = ( (base year basket quantities * current year prices) / (base year basket quantities * base year prices) ) * 100
The CPI is the Consumer Price Index, which measures the prices of goods and services purchased by households. The base year basket quantities are the quantities of goods and services in the CPI market basket in the base year. The current year's prices are the prices of goods and services in the CPI market basket in the current year. The base year prices are the prices of goods and services in the CPI market basket in the base year, which is used as the reference point for measuring price changes.
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There are a few steps to discuss when considering how to calculate price level. The first step is to multiply the base year basket quantities by the current year prices. This provides the numerator for the price level equation, which represents the current year's prices for the base year's basket of goods and services. The base year basket quantities are then multiplied by the base year prices. This provides the denominator for the price level equation, representing the base year's prices for the basket of goods and services. The numerator is then divided by the denominator, providing the current year's CPI. Finally, this number is multiplied by 100 to express the CPI as a percentage.
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It can be helpful to work through a few theoretical examples of calculating the price level and CPI to understand the process fully.
Example 1
Suppose the base year is 2010 and the current year is 2012. The base year basket of goods and services consists of the following:
| Good | Base-year quantity | base-year price | Base-year expenditure | Current-year price | Current-year expenditure |
|---|---|---|---|---|---|
| 1 pound of ground beef | 10 | $2.00 | $20.00 | $2.50 | $25.00 |
| 1 gallon of milk | 5 | $3.00 | $15.00 | $3.50 | $17.50 |
| 1 hamburger | 3 | $5.00 | $15.00 | $6.00 | $18.00 |
| $50.00 | $60.50 |
The current year's CPI would be:
CPI = ( (10*$2.50) + (5*$3.50) + (3*$6.00) ) / ( (10*$2.00) + (5*$3.00) + (3*$5.00) ) * 100
CPI = 121
The CPI has increased by 21% from the base to the current year. This means that prices have increased by 21% over this period.
Example 2
Suppose the base year is 2015 and the current year is 2016. The base year basket of goods and services consists of the following:
| Good | Base-year quantity | base-year price | Base-year expenditure | Current-year price | Current-year expenditure |
|---|---|---|---|---|---|
| 1 pound of coffee | 3 | $5.00 | $15.00 | $6.00 | $18.00 |
| 1 laptop | 2 | $1,000.00 | $2,000.00 | $1,250.00 | $2,500.00 |
| 1 pair of shoes | 5 | $100.00 | $500.00 | $120.00 | $600.00 |
| $2,515.00 | $3,118.00 |
The current year's CPI would be:
CPI = ( (3*$6.00) + (2*$1,250.00) + (5*$120.00) ) / ( (3*$5.00) + (2*$1,000.00) + (5*$100.00) ) * 100
CPI = 123.97
The CPI has increased by about 24% from the base to the current year. This means that prices have increased by 24% over this period.
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Price level is a measurement of the prices of goods and services produced in an economy at a given time. There are several ways to measure price level and price level changes, but the most popular method is the Consumer Price Index (CPI). The CPI looks at the prices of a representative basket of goods and services and then measures the changes in those prices over time. These goods and services can be divided into categories: food and beverage, housing, transportation, etc. CPI does not take into account investment goods such as stocks and bonds. The base year is the starting point from which price level changes are measured. The current year's CPI is calculated by taking the current year's prices and dividing them by the base year's prices. Then, the result is multiplied by 100 to express the CPI as a percentage. The equation can be expressed as:
CPI = ( (base year basket quantities * current year prices) / (base year basket quantities * base year prices) ) * 100
Two main economic situations and forces caused price level changes: inflation and deflation. Inflation is an increase in the overall prices of goods and services in an economy. Meanwhile, deflation decreases the overall prices of goods and services. There are several causes of inflation, such as an increase in the money supply, an increase in government spending, or an increase in production costs. Similarly, there are several causes of deflation, such as a decrease in the money supply or a decrease in demand. Therefore, calculating price level through CPI or other similar measurements can provide important insight into the current state of an economy, including inflationary/deflationary pressures and future economic trends.
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Video Transcript
Price Level Defined
Most of us are familiar with how a camera works. When we want to capture a particular moment so that we don't forget it, we immediately pull out our cell phones or cameras and snap a few shots. We've all done this at one time or another. Perhaps it was when our child reached a milestone, or we were reunited with a loved one we haven't seen in many years, or we were on vacation and saw a historical landmark.
Whatever the occasion, a camera has been the go-to source to preserve memories for years to come. But, what if we needed to visualize how the economy was performing at a particular time? Would a camera be efficient in documenting this kind of information? Probably not, but thankfully, economists have developed what we call a price level, which works in a similar fashion.
A price level is the measurement of current prices of goods and services produced in the economy in a specific region or country at a specific time. In simpler terms, price level can be compared to a picture we take with our cameras, only the picture is 'hypothetical' and is of the price of goods or services in a particular time frame. This picture allows economists to monitor changes to the price level.
Changes to the Price Level
In order to understand how to calculate price level, we need to explain situations that affect it. The first thing you need to know is that the price level can change. These changes are related to inflation and deflation. Inflation refers to an increase in the price level of goods, whereas deflation describes a decrease in the price level of goods.
Measuring Price Level
Perhaps the most popular way to measure price level is utilizing the consumer price index (CPI), which is an estimate of how common goods and services that consumers purchase change in price. You may be asking yourself right now, how are the prices of goods measured? Well, first of all, the government decides what goods and services are frequently purchased by average consumers and compiles a list. Since the list contains things a consumer would purchase, it is given the name consumer price index. Items range anywhere from bananas and crackers to a stove to a TV and even an amusement park ticket. However, the CPI doesn't include investments, like stocks or life insurance. The government then determines the price for every item on the list and calculates what the total cost would be for those items, known as the price level.
Price Level Equation
Now that we have the important pieces that are needed to calculate price level, let's try it out on an example. The following is the equation we can use to determine consumer price index, which we have learned is one of the more popular ways to find the price level.
CPI = [ (base year basket quantities * current year prices) / (base year basket quantities * base year prices) ] * 100
So, let's take a few common items many of us purchase, such as coffee, diapers, and hamburger.
| Good | Base-year quantity | Base-year price | Base-year expenditure | Current-year price | Current-year expenditure |
|---|---|---|---|---|---|
| Coffee | 10 | $12.00 | $120.00 | $12.25 | $122.50 |
| Diapers | 6 | $14.50 | $87.00 | $16.00 | $96.00 |
| Hamburger | 19 | $4.75 | $90.25 | $3.20 | $60.80 |
| $297.25 | $279.30 |
The base-year quantities, base-year price and the current-year price are just hypothetical numbers used for this example. The base-year expenditure, however, is calculated by multiplying base-year quantity and price. Current-year expenditure is calculated by multiplying current price by base-year quantity. The totals are determined by simply adding the column of numbers together.
Next, you take the totals for base-year expenditure and current-year expenditure and plug them into the equation, which gives you the CPI:
Current year CPI = (279.30 / 297.25) * 100 = 93.96
Keep in mind that the CPI for your base year is always 100, but if you want to calculate it, you can do so the following way:
(297.25 / 297.25) * 100 = 100
Lesson Summary
Price level can be compared to a snapshot taken with a camera of the current prices of goods and services at a particular time in the economy. Price level can change due to inflation and deflation. The most popular way to calculate price level is the consumer price index, which uses base prices and current prices.
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Price Level Definition, Equation & Calculation
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