Page 859 - Krugmans Economics for AP Text Book_Neat

S-13
SOLUTIONS TO AP REVIEW QUESTIONS

c. Decrease taxes, increase government purchases of goods Module 22
and services, or increase government transfers
Check Your Understanding
Module 21 1. The transaction costs for (a) a bank deposit and (b) a
Check Your Understanding share of a mutual fund are approximately equivalent
because each can typically be accomplished by making a
1. A $500 million increase in government purchases of phone call, going online, or visiting a branch office.
goods and services directly increases aggregate spending Transaction costs are highest for (c) a share of a family
by $500 million, which then starts the multiplier in business since finding a buyer for the share consumes time
motion. It will increase real GDP by $500 million × and resources. The level of risk is lowest for (a) a bank
1/(1 − MPC). A $500 million increase in government deposit, since these deposits are insured by the Federal
transfers increases aggregate spending only to the extent Deposit Insurance Corporation (FDIC) up to $250,000;
that it leads to an increase in consumer spending. somewhat higher for (b) a share of a mutual fund since
Consumer spending rises by MPC × $1 for every $1 despite diversification, there is still risk associated with
increase in disposable income, where MPC is less than 1. holding stocks; and highest for (c) a share of a family busi-
So a $500 million increase in government transfers will ness since this investment is not diversified. The level of
cause a rise in real GDP only MPC times as much as a liquidity is the lowest for (c) a share of a family business,
$500 million increase in government purchases of goods since it can be sold only with the unanimous agreement of
and services. It will increase real GDP by $500 million × other members and it will take some time to find a buyer;
MPC/(1 − MPC). higher for (b) a share of a mutual fund, since it will take
2. If government purchases of goods and services fall by only a few days between selling your shares and the pay-
$500 million, the initial fall in aggregate spending is ment being processed; and highest for (a) a bank deposit,
$500 million. If there is a $500 million tax increase, the since withdrawals can usually be made immediately.
initial fall in aggregate spending is MPC × $500 million, 2. Economic development and growth are the result of, among
which is less than $500 million because some of the tax other factors, investment spending on physical capital.
payments are made with money that would otherwise Since investment spending is equal to savings, the greater
have been saved rather than spent. the amount saved, the higher investment spending will be,
3. Boldovia will experience greater variation in its real GDP and so the higher growth and economic development will
than Moldovia because Moldovia has automatic stabiliz- be. So the existence of institutions that facilitate savings
ers while Boldovia does not. In Moldovia the effects of will help a country’s growth and economic development. As
slumps will be lessened by unemployment insurance ben- a result, a country with a financial system that provides low
efits, which will support residents’ incomes, while the transaction costs, opportunities for diversification of risk,
effects of booms will be diminished because tax revenues and high liquidity to its savers will experience faster growth
and economic development than a country that doesn’t.
will go up. In contrast, incomes will not be supported in
Boldovia during slumps because there is no unemploy- Tackle the Test:
ment insurance. In addition, because Boldovia has lump- Multiple-Choice Questions
sum taxes, its booms will not be diminished by increases
in tax revenue. 1. d
2. e
Tackle the Test:
Multiple-Choice Questions 3. a
1. c 4. d
2. b 5. b
3. b Tackle the Test:
4. c Free-Response Questions
5. e 2. Mutual fund–a financial intermediary that creates a
stock portfolio by buying and holding shares in compa-
Tackle the Test: nies and then selling shares of the stock portfolio to indi-
Free-Response Questions vidual investors.
Life insurance company–a firm that guarantees a
2. a. $50 million payment to the policyholder’s beneficiaries (typically, the
multiplier = 1/(1 − MPC) = 1/(1 − 0.75) = 1/0.25 = 4 family) when the policyholder dies.
change in G × 4 = $200 million Bank–an institution that helps resolve the conflict
change in G = $50 million between lenders’ needs for liquidity and the illiquid
b. 10 financing needs of borrowers who don’t want to use the
$20 × multiplier = $200 million stock or bond markets.
multiplier = 200/20 = 10 Pension fund–a nonprofit institution that collects the
c. 0.1 savings of its members and invests those funds in a vari-
1/(1 − MPC) = 1/MPS = 10 ety of assets, providing its members with income when
MPS = 0.1 they retire.