Question

If an economy has fully flexible 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

Effect of unexpected change in demand in the market

The unexpected increase in demand will shift the demand curve towards the right from D to D’. The equilibrium point will slide upwards along the same supply curve from e to e’. The prices and output will increase simultaneously to P’ and Q’, respectively, to reach a new equilibrium point e.’

Therefore, the supply and prices also boom to maintain equilibrium between supply and demand in the economy.

Effect of unexpected change in demand on the real GDP

As the production and prices have increased to P’ and Q’, the economy’s net worth will also boom for the financial year. Moreover, the real GDP will increase as the output has expanded from Q to Q’, though it will be a little less than the nominal GDP (as it considers both the price and output change).

The nominal GDP will measure the change in output at current prices. So it will include the price effect also. But real GDP will eliminate the price effect and only consider an increase in production at constant prices.