Page 860 - Krugmans Economics for AP Text Book_Neat

S-14 SOLUTIONS TO AP REVIEW QUESTIONS

Module 23 worth only $1/1.10 = $0.91. But when the interest rate is
2%, $1 arriving one year from today is worth $1/1.02 =
Check Your Understanding $0.98, a sizable increase. As a result, project B, which has
1. The defining characteristic of money is its liquidity: how a benefit one year from today, becomes more attractive.
easily it can be used to purchase goods and services. And project C, which has a cost one year from today,
Although a gift certificate can easily be used to purchase becomes less attractive.
a very defined set of goods or services (the goods or serv- Tackle the Test:
ices available at the store issuing the gift certificate), it Multiple-Choice Questions
cannot be used to purchase any other goods or services. A
gift certificate is therefore not money since it cannot eas- 1. e
ily be used to purchase all goods or services. 2. b
2. Again, the important characteristic of money is its liquid- 3. c
ity: how easily it can be used to purchase goods and serv- 4.
ices. M1, the narrowest definition of the money supply, d
consists only of currency in circulation, traveler’s checks, 5. b
and checkable bank deposits. CDs aren’t checkable–and
they can’t be made checkable without incurring a cost Tackle the Test:
because there’s a penalty for early withdrawal. This makes Free-Response Questions
them less liquid than the assets counted in M1. 3
3. Commodity-backed money uses resources more efficient- 2. a. $1,000 × (1.05) = $1,000 × 1.16 = $1,157.63
3
b. $1,000/(1.05) = $863.84
ly than simple commodity money, like gold and silver
coins, because commodity-backed money ties up fewer Module 25
valuable resources. Although a bank must keep some of
the commodity—generally gold and silver—on hand, it has Check Your Understanding
to keep only enough to satisfy demand for redemptions. 1.
It can then lend out the remaining gold and silver, which Even though you know that the rumor about the bank is
allows society to use these resources for other purposes, not true, you are concerned about other depositors
with no loss in the ability to achieve gains from trade. pulling their money out of the bank. And you know that
if enough other depositors pull their money out, the bank
Tackle the Test: will fail. In that case, it is rational for you to pull your
Multiple-Choice Questions money out before the bank fails. All depositors will think
1. d like this, so even if they all know that the rumor is false,
they may still rationally pull their money out, leading to
2. c a bank run. Deposit insurance leads depositors to worry
3. e less about the possibility of a bank run. Even if a bank
fails, the FDIC will currently pay each depositor up to
4. a $250,000 per account. This will make you much less like-
5. b ly to pull your money out in response to a rumor. Since
other depositors will think the same, there will be no
Tackle the Test: bank run.
Free-Response Questions 2. The aspects of modern bank regulation that would frus-
trate this scheme are capital requirements and reserve
2. a. its official status given by the U.S. government
b. fiat money requirements. Capital requirements mean that a bank has
c. commodity money–money that has intrinsic value in to have a certain amount of capital—the difference
other uses. between its assets (loans plus reserves) and its liabilities
Commodity-backed money–money that has no intrinsic (deposits). So the con artist could not open a bank with-
value but can be converted into valuable goods on out putting any of his own wealth in because his bank
demand. would need the required amount of capital—that is, it
needs to hold more assets (loans plus reserves) than
Module 24 deposits. So the con artist would be at risk of losing his
own wealth if his loans turn out badly.
Check Your Understanding 3. Since they have to hold only $100 in reserves, instead of
$200, banks now lend out $100 of their reserves.
1. a. The net present value of project A is unaffected by the
interest rate since it is money received today; its present Whoever borrows the $100 will deposit it in a bank (or
value is still $100. The net present value of project B is spend it, and the recipient will deposit it in a bank),
now −$10 + $115/1.02 = $102.75. The net present value which will lend out $100 × (1 − rr) = $100 × 0.9 = $90.
of project C is now $119 − $20/1.02 = $99.39. Project B The borrowed $90 will likewise find its way into a bank,
is now preferred. which will lend out $90 × 0.9 = $81, and so on. Overall,
b. When the interest rate is lower, the cost of waiting for deposits will increase by $100/0.1 = $1,000.
money that arrives in the future is lower. For example, at 4. Silas puts $1,000 in the bank, of which the bank lends
a 10% interest rate, $1 arriving one year from today is out $1,000 × (1 − rr) = $1,000 × 0.9 = $900. Whoever