Question

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

Short answer

Real GDP would increase.

Step-by-step solution

Understand the effect of flexible prices

In an economy with fully flexible prices, prices can adjust quickly to changes in demand and supply. This means that when demand increases, prices are likely to rise as sellers respond to the increased demand.

Analyze the impact on real GDP

With fully flexible prices, the increase in demand will cause prices to rise. However, the flexibility also means that suppliers can respond by increasing their output, or real GDP, to meet the higher demand at the new higher prices.

Conclude the effect on real GDP

Since prices and output can adjust, the overall effect when demand increases unexpectedly in an economy with fully flexible prices is that the real GDP will also increase as output meets the higher demand.

Key concepts

Flexible Prices

Flexible prices are a key feature of an economy where prices can change easily in response to shifts in demand and supply. This attribute allows markets to better allocate resources efficiently.
For example, if the demand for a particular product suddenly rises, flexible prices will allow sellers to increase the price to prevent excess demand. This makes it clear to producers that there is an opportunity to supply more.
Flexible prices ensure that they reflect real-time economic conditions, helping stabilize the economy by promoting balance between supply and demand. It's like an automatic adjustment tool that helps keep the economy on track.

Demand Increase

When the demand for goods and services increases unexpectedly, it generally indicates that consumers want to purchase more than before at current prices. In a world with flexible prices, this sudden rise in demand will lead to higher prices quickly.
Consumers effectively demand more because they are either willing to pay more or their ability to purchase has increased. This increase can sometimes be driven by factors like higher income levels, consumer trends, or changes in consumer tastes.
The important thing to note here is that the flexibility in prices enables the economy to adjust more rapidly to these shifts, reducing the likelihood of prolonged shortages or surpluses.

Economic Output

Economic output, often referred to as real GDP, measures the total value of all goods and services produced in the economy, adjusted for inflation. It's a vital indicator of an economy's health.
When demand increases in an economy with fully flexible prices, not only do prices adjust, but producers also modify their output levels. To meet the increased demand, they expand production, hire more workers, or use resources more intensively.
This adjustment helps prevent the economy from overheating or experiencing inflationary pressures as the increased output equals the higher demand, stabilizing the market.

Supply Response

A supply response occurs when producers react to changes in market conditions, such as increased demand or a change in prices. In economies with flexible prices, this response is relatively swift.
Producers, seeing an opportunity due to rising prices, are motivated to increase their output. This can involve ramping up production, investing in new technologies, or finding efficiencies to meet the new level of demand.
A quick supply response helps to maintain market equilibrium because it reduces the risk of inflation spiraling out of control. As prices rise in response to higher demand, the increase in supply ensures that any inflationary effects are moderated.