The key assumption of the basic IS-LM model is that, in the short run, firms:

Question

BlackTom AI · Accepted Answer

To understand the basic IS-LM model’s short-run assumption about firms, let's evaluate each option in turn with a focus on how firms typically behave in the short run.
Option a: 'change prices frequently.' In the short run, prices are often assumed to be sticky or fixed due to menu costs, contracts, and information frictions, so firms do not continuously adjust prices. This makes frequent price changes an unlikely core assumption.
Option b: 'adjust prices to bring sales in line with capacity.' While price adjustments can influence demand, the classic short-run IS-LM framework abstracts from rapid price changes and instead emphasizes demand-driven output with prices held constant. Therefore this option misstates the standard short-run focus on demand given fixed prices.
Option c: 'operate just as they do in the long-run.' The IS-LM short-run analysis distinguishes itself from the long run by allowing output to deviate from potential due to demand, with prices not instantly adjusting. Saying firms operate exactly as in the long run would ignore the short-run rigidity and output fluctuations central to the model.
Option d: 'meet demand at present prices.' This aligns with the short-run assumption that firms respond to current demand without needing immediate price adjustments; output is determined by demand relative to fixed prices, so firms aim to meet the level of demand given existing price levels.
Option e: 'produce potential output.' Producing at potential output implies full employment and price adjustments have already cleared markets, which is more characteristic of a long-run or idealized steady state, not the typical short-run IS-LM setup where output can be below or above potential due to demand shocks while prices remain sticky.
In summary, the core idea in the short-run IS-LM context is that with prices held fixed, firms respond by adjusting output to meet the prevailing demand at those present price levels, rather than actively altering prices or always producing potential output. The other options describe behaviors that contradict the standard short-run portrayal of price rigidity and demand-determined output. The phrasing of option d best captures this principle within the classical IS-LM framing.

The key assumption of the basic IS-LM model is that, in the short run, firms:Single choice

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