Final answer:
Deflation indicates that the aggregate price level is declining, not increasing. The relationship between price level and real GDP is explained through the Aggregate Supply curve, which indicates that higher prices for final goods with stable input costs lead to increased production.
Step-by-step explanation:
If an economy experiences deflation, this means that the aggregate price level is declining. Deflation is the opposite of inflation and occurs when the price levels of goods and services decrease over time. This could be a result of reduced consumer demand, increased productivity, or other factors leading to a surplus of supply over demand.
When examining the connection between the price level and real GDP, it's important to understand that the price level on the vertical axis usually represents prices for final goods or outputs bought in the economy, typically measured by the GDP deflator, and not the price level for intermediate goods. Therefore, the Aggregate Supply (AS) curve describes how suppliers will react to a higher price level for final outputs of goods and services, holding constant the prices of inputs like labor and energy. If firms are selling their final products at higher prices without a corresponding increase in production costs, the potential for higher profits will incentivize them to expand production, thereby increasing real GDP.