The Theory of the Price Level

So far the whole of our analysis has proceeded on the simplifying assumption that the price level is given and invariant. This does not mean that the level of prices exerts no influence in our model. Indeed if we look back at Chapter 11 we see that the price level is a determinant, of the demand for active (M₁ balances and thus of the rate of interest. Since the rate of interest, given the MEI schedule, determines (as explained in Chapter 10) the rate of real planned investment, which, in its turn, determines, via the multiplier, the equilibrium level of real income and, via the production function, the level of employment, it is clear that the level of prices exerts a considerable influence in our system. It is plain, therefore, that to complete our theory we need to consider how the price level itself gets determined. To explain this is the job of this chapter.