If in the income-expenditure model, firms increase their investments by $100 billion, how do they respond to this increased investment spending initially?
A) by increasing inventories by $100 billion
B) by drawing down inventories and increasing production by $100 billion
C) by increasing the price of goods and services
D) by waiting for demand to decrease
E) They will not respond to the increased demand, and will lose sales.

Question

Quizplus · Accepted Answer

In the income-expenditure model, an increase in investment spending by firms will lead to an increase in aggregate expenditure, which will shift the aggregate demand curve to the right. To meet the increased demand, firms will draw down inventories and increase production by $100 billion, as stated in choice B. This will result in an increase in output and employment in the short run, as long as the economy is not at full employment. Thus, choice B is the correct response. Choices A and C are not correct because an increase in investment spending does not necessarily lead to an increase in prices or inventories. Choice D is incorrect because waiting for demand to decrease is not a viable option for firms that want to remain competitive. Choice E is incorrect because firms will not lose sales if they respond to increased demand by increasing production.

If in the Income-Expenditure Model, Firms Increase Their Investments by $100