Question

If an economy has sticky prices and demand unexpectedly increases, you would expect the economy’s real GDP to

1. increase.

2. decrease.

3. remain the same.

Short answer

Option (a): increase

Step-by-step solution

Concept of real GDP

The real GDP measures the value of an economy’s total income based on constant prices. It indicates the growth in the economy’s net worth in terms of the output produced. Therefore, the real GDP follows the policy of sticky prices for estimating the economy’s growth.

Explanation for the correct option “a”

The unexpected increase in demand will shift the equilibrium point as given in the diagram from D to D’. However, the prices are sticky and cannot increase to meet this new demand curve. There cannot be an upward movement along the supply curve. The supply curve can only shift to the right to reach a new equilibrium from S to S’. The equilibrium quantity will increase as a result.

Therefore, only the economy’s output will increase at constant prices due to the demand-and-supply mechanism. Hence, the economy’s real GDP (constant prices) will increase with the unexpected increase in demand.