Introduction

To understand and use a macroeconomic model, we first need to understand how the average price of
all goods and services produced in an economy affects the total quantity of output and the total amount
of spending on goods and services in that economy.

The aggregate supply curve

Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in
turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like
labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of
output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the
total quantity of output—real GDP—that firms will produce and sell at each price level.

The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the
diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the
meaning of the potential GDP vertical line.

The aggregate supply curve

The graph shows an upward sloping aggregate supply curve. The slope is gradual between 6,500 and
9,000 before become steeper, especially between 9,500 and 9,900.
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The
vertical axis shows the price level. Price level is the average price of all goods and services produced in
the economy. It's an index number, like the GDP deflator.

[Wait, what's a GDP deflator again?]

The GDP deflator is a price index measuring the average prices of all goods and services included in the
economy.

Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services
supplied—rises as well. Why do you think this is?

The price level shown on the vertical axis represents prices for final goods or outputs bought in the
economy, not the price level for intermediate goods and services that are inputs to production. The AS
curve describes how suppliers will react to a higher price level for final outputs of goods and services
while the prices of inputs like labor and energy remain constant.

If firms across the economy face a situation where the price level of what they produce and sell is rising
but their costs of production are not rising, then the lure of higher profits will induce them to expand
production.