Question

If an economy has sticky prices and demand unexpectedly increases, you would expect the economy’s real GDP to: a. Increase. b. Decrease. c. Remain the same.

Short answer

The economy's real GDP is expected to increase.

Step-by-step solution

Understanding Sticky Prices

Sticky prices refer to the resistance of prices to change, particularly downward, in response to changes in the economy. This means that when demand shifts, prices do not immediately adjust to match the new level of demand.

Analyzing Demand and GDP Relationship

When demand increases unexpectedly, it implies that consumers are willing to buy more goods and services at the current price level. Since prices are slow to adjust due to their 'stickiness,' the immediate effect is an increase in production to meet the higher demand.

Impact on Real GDP

Real GDP measures the value of goods and services produced in an economy, adjusted for price changes. With higher production due to increased demand and sticky prices preventing immediate price changes, real GDP tends to rise.

Key concepts

Real GDP

Real GDP stands for Real Gross Domestic Product. It's a crucial indicator that measures the economic production of a country, but it does so by adjusting for inflation or deflation.

In simpler terms, Real GDP looks at what a country produces without the distorting effect of changing prices. This makes it a more accurate reflection of an economy's size and how it's performing over time.

Imagine you've baked cakes this year and last year. If you made 100 cakes both years, but the price of cakes doubled, your GDP would say you made twice as much money. But realistically, you made the same number of cakes each year. That's where Real GDP helps; it keeps the comparison fair by factoring out price changes.

Demand and Supply

Demand and supply are fundamental concepts in economics that determine the economy's overall balance.

**Demand** refers to how much of a good or service people are willing and able to purchase at various prices. It can fluctuate due to factors like income changes or price shifts in related goods.

**Supply**, on the other hand, describes how much the market can offer. Generally, businesses will supply more of a product if consumers are willing to pay more for it.

In a balanced market, supply meets demand. However, when demand unexpectedly increases, this can disrupt the balance, especially if prices remain sticky and don't adjust quickly.

Economic Production

Economic production is the process of creating goods and services in an economy. It reflects how resources are used to produce what consumers want.

When we talk about increasing production, it usually means businesses are making more goods or services because there is a higher demand.

• A surge in consumer demand can push businesses to ramp up production quickly.
• This can involve using existing resources more efficiently or bringing in additional resources—like hiring more workers or increasing factory hours—to meet the surge.

In cases of sticky prices, businesses often look to produce more to meet demand, as prices don't adjust as promptly to match the new demand level.

Price Adjustment

Price adjustment is the process by which prices change in response to changes in the market, such as shifts in supply or demand.

In an ideal scenario, prices fluctuate freely and rapidly to balance demand and supply. However, sticky prices hinder this natural adjustment.

• Sticky prices occur when prices are slow to change, often because of menu costs (the cost of changing prices) or long-term contracts.
• With sticky prices, when demand rises suddenly, prices don't increase as fast, leaving room for production to increase instead, which can boost Real GDP.

Understanding price adjustment helps explain how markets can sometimes become temporarily inefficient and why businesses might increase production, even when prices don't immediately rise.