An increase in aggregate demand will cause which of the following in the short run, assuming the economy is operating below full employment?

• A. A decrease in real GDP and an increase in the price level
• B. A decrease in real GDP and the price level
• C. An increase in real GDP and the price level
• D. No change in real GDP or the price level

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the initial condition — the economy is operating below full employment, meaning there is unused capacity and unemployment is higher than the natural rate.
2. Step 2: Recall that an increase in aggregate demand (AD) shifts the AD curve to the right, which tends to increase both output (real GDP) and the price level in the short run.
3. Step 3: Since the economy is below full employment, firms can increase production without causing large increases in costs, so real GDP rises as firms respond to higher demand.
4. Step 4: The increase in demand also puts upward pressure on prices, causing the price level to rise, but the increase in output is the dominant effect in the short run.
5. Step 5: Conclude that the short-run effect of an increase in aggregate demand when the economy is below full employment is an increase in both real GDP and the price level.