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Price level is the average of current prices across the entire spectrum of goods and services produced in an economy. In more general terms, price level refers to the price or cost of a good, service, or security in the economy. Price levels may be expressed in small ranges, such as ticks with securities prices, or presented as a discrete value such as a dollar figure. In economics, price levels are a key indicator and are closely watched by economists. They play an important role in the purchasing power of consumers as well as the sale of goods and services. It also plays an important part in the supply-demand chain.
There are two meanings of the term price level in the world of business. The first is what most people are accustomed to hearing about: the price of goods and services or the amount of money a consumer or other entity is required to give up to purchase a good, service, or security in the economy. Prices rise as demand increases and drop when demand decreases. The movement in prices is used as a reference for inflation and deflation, or the rise and fall of prices in the economy. If the prices of goods and services rise too quickly—when an economy experiences inflation—a central bank can step in and tighten its monetary policy and raise interest rates. This, in turn, decreases the amount of money in the system, thereby decreasing aggregate demand. If prices drop too quickly, the central bank can do the reverse; loosen its monetary policy, thereby increasing the economy's money supply and aggregate demand. The other meaning of price level refers to the price of assets traded on the market such as a stock or a bond, which is often referred to as support and resistance. As in the case of the definition of price in the economy, demand for a security increases when its price drops. This forms the support line. When the price increases, a sell-off occurs, cutting off demand. This is where the resistance zone lies. In economics, price level refers to the buying power of money or inflation. In other words, economists describe the state of the economy by looking at how much people can buy with the same dollar of currency. The most common price level index is the consumer price index (CPI). The price level is analyzed through a basket of goods approach, in which a collection of consumer-based goods and services is examined in aggregate. Changes in the aggregate price over time push the index measuring the basket of goods higher. Weighted averages are typically used rather than geometric means. Price levels provide a snapshot of prices at a given time, making it possible to review changes in the broad price level over time. As prices rise (inflation) or fall (deflation), consumer demand for goods is also affected, which leads to changes in broad production measures such as gross domestic product (GDP). Price levels are one of the most watched economic indicators in the world. Economists widely believe that prices should stay relatively stable year to year so that they don't cause undue inflation. If price levels rise too quickly, central banks or governments look for ways to decrease the money supply or the aggregate demand for goods and services.
Although prices change gradually over time during inflationary periods, they can change more than once a day when an economy experiences hyperinflation. Traders and investors make money by buying and selling securities. They buy and sell when the price reaches a certain level. These price levels are referred to as support and resistance. Traders use these areas of support and resistance to define entry and exit points. Support is a price level where a downtrend is expected to pause due to a concentration of demand. As the price of a security drops, demand for the shares increases, forming the support line. Meanwhile, resistance zones arise due to a sell-off when prices increase. Once an area or zone of support or resistance is identified, it provides valuable potential trade entry or exit points. This is so because as a price reaches a point of support or resistance, it will do one of two things: bounce back away from the support or resistance level or violate the price level and continue in its direction until it hits the next support or resistance level.
Chapter 11 Aggregate Supply Aggregates Supply is the relationship between the price level in the economy and the quantity of aggregate output firms are willing and able to supply, other things constant. The greater the supply of resources, the better the technology, the more effective production incentives, provided by economic institutions, the greater aggregate supply. I. Deriving the Aggregate Supply in the Short RunA. Labor DemandThe demand for labor is derived from its productivity, which in turn depends upon capital (including human capital), other resources, and technology. If the production function increases the demand for labor rises (and vice versa). Profit maximizing firms will hire when the real wage equals the marginal physical product of labor. B. Labor Supply Labor is the most important resource – 70% of production costs. The higher the wage, the more willing and able people are to work, supply labor hours. Nominal wage – the wage measured in terms of current dollars; the dollar amount on a paycheck Real wage – the wage measured in terms of dollars of constant purchasing power; hence, the wage measured in terms of the quantity of goods and services it will purchase The higher the price level, the less any given dollar wage (nominal wage) will purchase, so the less attractive that dollar wage is to workers. Wage contracts are generally settled in terms of nominal wages. So workers and firms reach agreements based on the expected price level (and the expected real wage). C. Equilibrium in the Labor Market Determines Potential Output and the Natural Rate of Unemployment Example: Resource owners and firms negotiate the wage based on what they expect the inflation rate to be. If firms and resource owners expect inflation to be 3%, they may agree on a wage increase of 4% this year (or 1% increase in real wages). If inflation turns out to be 3%, the agreed-upon wage is the expected real wage, so everyone is happy. The potential output is the output produced when there are no surprises associated with the price level. Potential Output – The economy’s maximum sustainable output level, given the supply of resources, technology, and production incentives; the output level when there are no surprises about the price level. (natural rate of output, full-employment output) Natural Rate of Unemployment – The unemployment rate that occurs when the economy is producing its potential level of output. When actual price level turns out as anticipated, the expectations of both workers and firms are fulfilled, and the economy produces its potential output. Potential Output and Short-run Aggregate SupplyA. Employment can exceed the potential level if real wages are below the market clearing level. B. Employment is below potential if real wages are above the market clearing level C. Why sticky wages can result in non-market clearing real wages and employment. D. How the actual price level different from the expected price level affects non-market clearing real wages and employment Actual Price Level Higher than ExpectedShort run – A period during which at least some resource prices, especially those for labor, are fixed by agreement. Suppose that given an expected price level, a firm and its workers have agreed on a wage. What happens if the price level turns out to be higher than expected? à Firms are happy. They receive a higher price for what they are selling while wages are fixed. Because a price level that is higher than expected results in higher profits, firms have an incentive in the short run to expand production beyond the economy’s potential level. (beyond “normal capacity”) 1. Why Costs Rise When Output Exceeds Potential As output expands, the cost of additional output increases. a. Economy expands à unemployment declines à extra workers become hard to find (They may need extra pay to draw them into the labor force, they may be less qualified, you may have to pay premiums for overtime hours.) The nominal cost of labor increases as output expands in the short run. (Even though wages are fixed by contract.) b. Production increases à demand for other resources (non-labor) increases as well. à prices for these resources will increase due to greater scarcity. Firms expand production as long as revenue from additional production exceeds costs. **Because the prices of some resources are fixed by contracts, the price level rises faster than the per-unit production cost, so firms increase the quantity supplied. 2. Why are workers willing to increase their labor supply? When the price level exceeds expectations (real wages fall), why are workers willing to increase their labor supply? The impact of a money illusion, when nominal wages increase even though real wages decrease. Efficiency Wage Theory – The idea that keeping wages above the level required to attract a sufficient pool of workers makes workers compete to get and keep their jobs and results in greater productivity. Actual Price Level Lower than ExpectedResource suppliers and firms expect a certain price level. If the price level is lower than expected, production is less profitable, firms reduce their quantity supplied, so the economy’s output is below its potential. - some workers laid off - those who keep jobs may work fewer hours - unemployment exceeds the natural rate ReviewPrice level higher than expected à firms increase quantity supplied beyond potential output, per-unit cost of additional production increases Price level lower than expected à firms reduce output below potential output, There is a direct relationship between the actual price level and the quantity of aggregate output supplied. Deriving the Short-Run Aggregate Supply CurveShort-run aggregate supply curve (SRAS) – A curve that shows the direct relationship between the price level and the quantity of aggregate output supplied in the short run. Short run - Period of time in which some resource prices fixed (like those for labor). Think of short run as the duration of labor contracts. Suppose the expected price level is 130. If the price level turns out to be 130 à producers supply the economy’s potential output à unemployment is at the natural rate A higher price level increases output, if the expected price level does not change, since the real wage rate decreases. The slope of the SRAS curve depends on how sharply the cost of additional production rises as aggregate output expands. It becomes steeper as output increases because resources become scarcer. II. From the Short Run to the Long RunA. Actual Price Level Higher than Expected Expected price level of 130. Equilibrium price and output depend on aggregate demand. If Aggregate Demand is greater than expected, short-run equilibrium may not be at a price level of 130. 1. Short-run Equilibrium Short-run Equilibrium – Combination of price level and real GDP, where the aggregate demand curve intersects the short-run aggregate supply curve. Expansionary Gap – The amount by which actual output in the short run exceeds the economy’s potential output. When real GDP exceeds potential GDP, employment is less than the natural rate. à Employees working over time. à Machines are pushed to the limit. à Farmers put extra crops between usual plantings. Nominal wage based on expected price level of 130 is a lower real wage. The more the short-run output exceeds the economy’s potential, the larger the expansionary gap and the greater the upward pressure on the price level. 2. Long-run Equilibrium Long Run – A period during which wage contracts and resource price agreements can be renegotiated; the level of output when there are no price surprises. 1. Because higher than expected price levels makes real wage lower than expected, when workers have the chance to renegotiate, they will want a higher wage. 2. This raises production costs for the firm. 3. Short run supply curve shifts to the left, reflecting higher expected price level. Long-run Equilibrium – Combination of price level and real GDP, where 1. Actual price level equals expected price level 2. Quantity supplied equals potential output, and 3. Quantity supplied equals quantity demanded. In real terms, the situation is no different at point a than at point c. B. Actual Price Level Lower than Expected Expected price level of 130. Equilibrium price and output depend on aggregate demand. If Aggregate Demand is less than expected, short-run equilibrium may not be at a price level of 130. 1. Short-run Equilibrium Contractionary Gap – The amount by which actual output in the short run falls below the economy’s potential output. à Nominal wage negotiated translates into a higher wage in the short run. 2. Long-run Equilibrium Long Run à Since price level is lower, firms no longer willing to pay a higher nominal wage. à Unemployment higher than the natural rate à More workers compete for jobs, putting downward pressure on the wage. à Firms negotiate lower wages, lowers the cost of production, supply curve shifts down. If the price level and nominal wage are flexible enough, the short-run aggregate supply curve will move outward until the economy produces its potential output. Graph: C. Tracing Potential Output If wages and prices are flexible enough, the economy will produce its potential level of output in the long run. Long-run Aggregate Supply Curve – The vertical line drawn at the economy’s potential output; aggregate supply when there are no price surprises. LRAS depends on the supply of resources in the economy, the level of technology, and the production incentives provided by the formal and informal institutions of the economic system. Equilibrium price level depends on AD. D. Evidence on Aggregate Supply Natural Rate estimates range from 4 to 6% - Expansionary gaps create labor shortages that lead to higher nominal wages. - Contractionary gaps often don’t put enough downward pressure on wages. Studies show that the nominal wage is slow to adjust to high unemployment. III. Changes in Aggregate Supply A. Increases in Aggregate Supply LRAS depends on 1. willingness and ability of households to supply resources 2. technology 3. economic system Example: Increase in the quality and quantity of the labor force. (Gradual increase in the supply of resources.) Beneficial Supply Shocks – Unexpected events that increase aggregate supply, sometimes only temporarily. -Abundant harvests -Discoveries of natural resources -Technological breakthrough B. Decrease in Aggregate Supply Adverse Supply Shocks – Unexpected events that reduce aggregate supply, sometimes only temporarily. If the effect is temporary, only the short run supply curve shifts. |
When the actual price level in an economy is lower than the expected price level, _____.
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