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

a. Increase.

Step-by-step solution

Understanding Sticky Prices

Sticky prices refer to the situation where prices of goods and services do not change quickly in response to changes in supply or demand. This often happens due to contracts, menu costs, and other frictions that prevent prices from adjusting immediately.

Analyzing Demand Increase

When demand unexpectedly increases, consumers want to buy more goods and services at the current price level. This puts upward pressure on the quantity of goods and services sold, since the price cannot adjust quickly due to sticky prices.

Determining the Effect on Real GDP

Real GDP measures the value of all finished goods and services produced within an economy. An increase in demand, with sticky prices, leads producers to increase production to meet the higher demand, thereby raising real GDP.

Key concepts

Understanding Real GDP

Real GDP stands for Real Gross Domestic Product, a critical indicator of an economy's health. This metric measures the total value of all goods and services produced in an economy, adjusted for inflation.
This adjustment is crucial because it offers a more accurate view of an economy's growth by eliminating the effect of price changes. Real GDP gives insight into an economy's size and how it's growing over time.

• If more goods and services are produced compared to the previous period, real GDP rises.
• Thus, real GDP is viewed as a direct reflection of increased economic activity and production.

Effects of Demand Increase

When there's a spike in demand, consumers want to purchase more goods and services. This increase is not simply a trend or a seasonal fluctuation. It refers to a notable rise in consumer interest and purchasing power. The forces behind such an increase might include:

• Improved consumer confidence: When consumers feel optimistic about the future, they tend to spend more.
• Higher incomes: Economic policies or circumstances lead to more disposable income.
• Decrease in interest rates: Lower borrowing costs encourage spending over saving.

Sticky prices, which don't adjust quickly, mean that even with this demand surge, prices remain stable initially. Consequently, the primary response is an increase in the quantity of goods produced and sold rather than a price change.

Economic Production Processes

Economic production represents the activities businesses engage in to convert resources into goods and services. With fixed prices due to stickiness, businesses respond to increased demand by ramping up production. This decision is influenced by the potential to sell more without a price hike, which is advantageous for profits. Production generally involves:

• Utilizing labor, capital, and raw materials efficiently.
• Adjusting work shifts and improving machinery usage to meet higher output needs.
• Focusing on high-demand products to maximize resource utilization.

In essence, while initial production adjustments aim to satisfy immediate demand, businesses might need to plan further for long-term changes if demand seems persistent.

Price Adjustment Mechanisms

Price adjustment refers to how prices respond to market changes over time. Sticky prices mean that immediate price flexibility is limited. Instead of adjusting prices right away, markets initially respond by altering production volumes. However, over time, producers might need to adjust prices for several reasons:

• To cover increased production costs due to longer shifts or material shortages.
• To stabilize supply and demand by gradually correcting any imbalance in price levels.
• To align with competitors who might eventually raise prices as well.

Ultimately, while sticky prices delay immediate changes, adjustments are likely if demand changes persist, ensuring that markets reach a new equilibrium.