AP_Krugman_Textbook

Summary 293

the equilibrium point (E 1 ) and the equilibrium interest

rate (r 1 ).

b.Now consider a new diagram with the cost of the war in-

cluded in the analysis. Shift the demand curve in the appro-

priate direction. Label the new equilibrium point (E 2 ) and

the new equilibrium interest rate (r 2 ).

c.How does the equilibrium interest rate change in response

to government expenditure on the war? Explain.

21.How would you respond to a friend who claims that the gov-
ernment should eliminate all purchases that are financed by
borrowing because such borrowing crowds out private invest-
ment spending?

22.Boris Borrower and Lynn Lender agree that Lynn will
lend Boris $10,000 and that Boris will repay the $10,000
with interest in one year. They agree to a nominal interest
rate of 8%, reflecting a real interest rate of 3% on the loan
and a commonly shared expected inflation rate of 5% over
the next year.
a.If the inflation rate is actually 4% over the next year, how
does that lower-than-expected inflation rate affect Boris
and Lynn? Who is better off?
b.If the actual inflation rate is 7% over the next year, how does
that affect Boris and Lynn? Who is better off?

23.Using the accompanying diagram, explain what will happen
to the market for loanable funds when there is a fall of

2 percentage points in the expected future inflation rate.

How will the change in the expected future inflation rate af-

fect the equilibrium quantity of loanable funds?

24.Using a figure similar to Figure 29.7, explain how the money

market and the loanable funds market react to a reduction in

the money supply in the short run.

25.Contrast the short-run effects of an increase in the money sup-

ply on the interest rate to the long-run effects of an increase in

the money supply on the interest rate. Which market deter-

mines the interest rate in the short run? Which market does so

in the long run? What are the implications of your answers for

the effectiveness of monetary policy in influencing real GDP in

the short run and the long run?

Quantity of

loanable funds

Interest

rate

Q 1

S 1

8%

0

D 1

E 1

r 1

Section 5 Summary