What it means
There is no single price for everything, so economists build an index that tracks the cost of a typical basket of goods and services, such as food, housing, transport and healthcare. The value of that basket, set against a chosen base year, is the price level.
Common measures include the consumer price index, which follows what households buy, and the GDP deflator, which covers everything produced in the economy. The price level is not the same as inflation, though the two are linked.
The price level is the height of the index at one point in time, while inflation is the rate at which that height changes. If the index goes from 250 to 257.5 in a year, the price level has risen and inflation is 3%.
For businesses, the price level matters because it shapes costs, wages, contracts and pricing. When it rises quickly, suppliers raise prices, staff ask for pay rises and interest rates often go up.
When it falls, revenue can shrink and debts become heavier in real terms, because each dollar owed is worth more. Finance teams use the price level to convert nominal figures into real ones.
A nominal figure is expressed in the money of the day, while a real figure has been adjusted to remove the effect of changing prices. A company whose sales grew 5% in a year when the price level rose 3% has seen real growth of only about 2%.
Central banks watch the price level closely, because stable prices are a core aim of monetary policy. They raise interest rates to cool demand when prices climb too fast, and cut rates when prices are weak.
Their decisions then feed through to loans, mortgages and investment returns. Be aware that different indices give different answers.
A household that spends heavily on rent or fuel may experience a higher personal price level than the national average, so use the measure that best matches the exposure you are analysing.
In practice
Real-world examples.
Example
A manufacturer signs a three-year supply contract with a clause linking prices to a consumer price index. When the price level rises 4% in a year, the contract price rises by the same amount. The finance team budgets for this when forecasting costs.
Example
An analyst compares a retailer's sales over ten years. Nominal sales doubled from $50,000,000 to $100,000,000, but the price level rose 60% in the same period. In real terms, sales grew only about 25%, because $100,000,000 / 1.6 = $62,500,000.
Example
A landlord has a lease that lets her raise rent each year in line with the price level. In a year with 3% inflation, a $4,000 monthly rent becomes $4,120. This protects the real value of her income.
Formula
Calculation
Price level index = (cost of basket today / cost of basket in base year) x 100; inflation rate = (index end - index start) / index start x 100%.
A basket cost $500 in the base year and costs $1,250 today, so the price level index = $1,250 / $500 x 100 = 250. A year later the basket costs $1,287.50, so the index = $1,287.50 / $500 x 100 = 257.5. Inflation = (257.5 - 250) / 250 = 7.5 / 250 = 0.03, or 3%. Money has lost purchasing power, because $100 now buys only about $100 / 1.03 = $97.09 of last year's goods.Case study
Seen in the real world.
Harbour Lane Furniture is a fictional manufacturer used here for illustration. Over four years its reported revenue grew from $20,000,000 to $24,000,000, which the board welcomed as 20% growth.
The finance manager then adjusted the figures for the price level, which had risen 15% over the same period. Real revenue was $24,000,000 / 1.15 = about $20,870,000, so real growth was only around 4%.
The illustrative board used the result to refocus on volume growth and cost control. It also added price-level assumptions to its budgeting, so future targets were set in real terms as well as nominal ones.
Watch out
Common mistakes.
- Using the price level and inflation as if they were the same thing. One is a level and the other is the rate of change.
- Comparing figures from different years without adjusting. Nominal comparisons overstate real growth when prices are rising.
- Assuming the national index fits your business. Your own costs may rise faster or slower than the average.
Questions
People also ask.
What is the consumer price index?
It is a measure of the average change in the prices households pay for a basket of goods and services over time.
What is deflation?
It is a sustained fall in the price level, which can reduce profits and make debts harder to repay.
How do I convert nominal to real figures?
Divide the nominal amount by the price level index and multiply by 100, using a consistent base year.
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