How does aggregate demand affect price level?

Prices coordinate supply and demand, and they are also determined by it; there is no clean, direct and one-dimensional link between aggregate demand and general price levels. Under ceteris paribus conditions, however, a rightward shift in aggregate demand corresponds with an increase in the price level, while a leftward shift corresponds with a lower price level.

In macroeconomics, aggregate demand is defined as the total quantity of goods and services demanded in an economy. The classic equation for calculating aggregate demand is gross domestic product, or GDP: total consumption spending + investments + government spending + net exports.

The general price level is purely hypothetical; there is obviously no uniform price for the many types of goods and services in the economy. Most price level estimates are calculated by tracking a set basket of goods and services. The price level is most significant in real terms. In other words, real price levels compare the prices of goods and services against the purchasing power of money.

Microeconomics and macroeconomics treat supply and demand somewhat differently. According to the law of demand, any increase in prices tends to cause the demand for a good or service to decline. Macroeconomists, however, normally consider rising nominal prices as crucial for future economic demand. The nuances of this disagreement lie at the heart of many economic debates. Yet, in relative terms, the influence of total demand on prices is clear.

Whenever a group of consumers demand more goods or services, the prices for those goods or services goes higher than normal. However, this does not mean real prices have to rise.

For example, people demand HDTVs more than ever, yet their real costs have declined. If real prices were to decline even further, demand would tend to increase. In other words, more people would be willing to buy $100 TVs than $1,000 TVs.

It is very difficult to determine if prices are causing movement along a demand curve or if a shifting demand curve is causing price movement.