Page 867 - Krugmans Economics for AP Text Book_Neat

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SOLUTIONS TO AP REVIEW QUESTIONS

less than what they lent out. No lending would take Tackle the Test:
place. It is better to hold cash than to pay people to bor- Free-Response Questions
row money.
e. Conventional monetary policy (decreasing interest rates) 2. a. The aggregate supply curve is vertical so changes in the
can’t happen if the nominal interest rate is already zero. money supply affect only the aggregate price level.
This is called the zero bound OR a liquidity trap. b. Changes in aggregate demand will affect aggregate out-
put.
Module 35 c. Business cycles are associated with fluctuations in the
money supply.
Check Your Understanding d. To avoid inflation, the unemployment rate must be set so
1. A classical economist would have said that the aggressive that actual inflation equals expected inflation.
monetary expansion would have had no short-run effect e. Individuals and firms make optimal decisions using all
available information.
on aggregate output and would simply have resulted in a f. Fluctuations in total factor productivity growth cause the
proportionate increase in the aggregate price level. business cycle by causing the vertical aggregate supply
2. Monetarists argue that central banks should implement curve to shift.
policy so that the money supply grows at some constant
rate. Had the Fed pursued a monetarist policy during this
period, we would have observed movements in M1 that Module 36
would have shown a fixed rate of growth. We would not, Check Your Understanding
therefore, have observed any of the reductions in M1 that
are observed in the figure, nor would we have observed 1. The modern consensus has resolved the debate over the
the acceleration in the rate of growth of M1 that effectiveness of both expansionary fiscal and monetary
occurred in 2001. policy. Expansionary fiscal policy is considered effective,
3. As in Problem 2, a monetarist policy would have resulted although it is limited by the problem of time lags, making
in a constant rate of growth in M1. Between 1996 and monetary policy the stabilization tool of choice except in
2000 the velocity of M1 rose steadily. After 2000 the special circumstances. Expansionary monetary policy is
velocity leveled off a bit and then rose again. Given a considered effective except in the case of a liquidity trap.
constant rate of money growth, these increases in the The modern consensus has not resolved, however,
velocity of M1 would have been expansionary, causing whether the Fed should adopt an inflation target,
increases in aggregate demand and the aggregate price whether it should use monetary policy to manage asset
level, other things equal. price bubbles, and what, if any, kind of unconventional
4. The advocacy of fiscal policy (here in the form of tax cuts) monetary policy it should use in the situation of a liquid-
ity trap.
to boost economic activity is Keynesian because Keynes pro-
moted fiscal policy as a useful tool to dampen fluctuations Tackle the Test:
in the business cycle. The praise of aggressive monetary pol-
icy is not Keynesian because Keynes worried that a liquidity Multiple-Choice Questions
trap would thwart the ability of monetary policy to change 1. d
interest rates and influence investment spending.
2. c
5. a. Rational expectations theorists would argue that only 3.
unexpected changes in money supply would have any e
short-run effect on economic activity. They would also 4. a
argue that expected changes in the money supply would 5. c
affect only the aggregate price level, with no short-run
effect of aggregate output. So such theorists would give Tackle the Test:
credit to the Fed for limiting the severity of the 2001
recession only if the Fed’s monetary policy had been more Free-Response Question
aggressive than individuals expected during this period. 2. Your answer can look like the diagram below, or it can
b. Real business cycle theorists would argue that the Fed’s have the axes reversed and a curve that resembles a
policy had no effect on ending the 2001 recession mountain.
because they believe that fluctuations in aggregate output
are caused largely by changes in total factor productivity.
Tax
Tackle the Test: rate
Multiple-Choice Questions
1. e
2. d
3. b
4. a
5. d Tax revenue