Real output and the price level measure different changes.
An aggregate demand and aggregate supply diagram relates the general price level to real national output over a stated period. Real output measures production with price changes removed; the general price level summarises prices across the economy. Put the general price level on the vertical axis and real output on the horizontal axis. A change in one product's price is not the same as a change in the general price level. A higher equilibrium price level after a shock is also not, by itself, evidence that prices will keep rising at the same rate in subsequent years.
- The whole economy
- Aggregate means the economy as a whole. Aggregate demand (AD) describes planned spending on domestic output; aggregate supply (AS) describes the output producers will provide at each general price level.
- Vertical axis
- The general price level, labelled P, summarises prices across the economy. It is not the price of one product.
- Horizontal axis
- Real output, labelled Y, measures production over a period with the effect of price changes removed. More money spent does not necessarily mean more goods and services produced.
- Level and rate
- Inflation is a rise in the general price level over time. A move between two price levels does not show that the same rate of increase continues in later periods.
Apply the idea
Reading indices
An index is a comparison scale, often starting from 100. An output index rising from 100 to 120 means (120 - 100)/100 x 100 = 20% more real output. These index points are not dollars.
What is outside this graph
Employment, distribution, leisure and environmental effects require additional relationships or evidence.
Worked example: Output index 120, price index 110
A diagram uses a general-price index P and real-output index Y, both initially 100. After a demand increase, equilibrium moves to P = 110 and Y = 120. The diagram contains no further time periods.
- The economy produces 20% more real output relative to the starting index. This is not merely a rise in money spending caused by higher prices.
- The general price index is 10% above its starting level. The change applies to the aggregate index, not necessarily every individual price.
- The two equilibria illustrate a change in output and the price level. A time series is needed to describe continuing inflation or its changing rate.
- These indices do not show distribution, leisure or environmental effects. Detailed living-standard comparisons require additional evidence.
Watch out for this
A rise in money spending always proves a rise in real output.
Money spending can rise because prices rise, quantities rise or both. Read the real-output measure separately.
Check your understanding
Which belongs on the horizontal axis of a standard AD/AS diagram?
- The price of one cup of coffee.
- Real national output per period.
- The annual inflation rate.