Answers to Text Questions and Problems in Chapter 8
Answers to Review Questions
The key assumption is that, in the short run, firms meet demand at pre-set prices. The fact that firms
produce to meet demand implies that changes in demand affect output in the short run.
Many examples are possible. Goods that are standardized and are bought and sold in large quantities,
such as wheat or other commodities, tend to have rapidly adjusting prices, for the reason that the benefits
of setting up active auction markets for such goods usually exceed the costs. Goods such as clothing
items, which are not standardized (they vary in size, colour, style) and which are usually sold in retail
stores one by one, tend to have prices that are changed less frequently.
Planned aggregate expenditure is total planned spending on final goods and services. It includes
consumption spending, investment spending, government purchases of goods and services, and net
exports (exports less imports). Changes in output are reflected in changes in income received by
producers, which in turn affects consumption spending (through the consumption function). As
consumption is part of aggregate expenditure, changes in output lead to changes in aggregate expenditure.
Planned spending includes planned additions to inventories to firms. If firms’ actual sales differ from
what they planned, their additions to inventories will likewise differ from what was planned, and actual
spending will differ from planned spending. For example, suppose that a firm planned to produce 100
units, sell 90 units to the public, and add 10 units to its inventory. But in fact the firm sells only 80 units
and thus must add 20 units to inventory. The firm’s planned inventory investment (a component of
investment and thus total spending) was 10 units, but its actual inventory investment was 20 units. So the
firm’s actual investment spending (inclusive of inventory investment) is greater than it planned. On the
other hand, if the firm sold all 100 units, it would add nothing to inventory, and its actual investment
(including inventory investment) would be less than planned.
See Figure 8.1. Consumption,
, is on the vertical axis and disposable income,
, is on the
horizontal axis. A movement from left to right along the graph of the consumption function indicates an
increase in consumption as disposable income increases. A parallel upward shift of the consumption
function indicates that people are consuming more at any given level of disposable income, i.e., some
factor other than a change in disposable income is stimulating consumption.
See Figure 8.3. The 45-degree line captures the definition of short-run equilibrium output,
Y = PAE
Short-run equilibrium output must lie on that line. The expenditure line shows how planned aggregate