AP_Krugman_Textbook

342 section 6 Inflation, Unemployment, and Stabilization Policies

2. Consider the accompanying diagram.

a. What is the nominal interest rate if expected inflation is 0%?

b. What would the nominal interest rate be if the expected

inflation rate were −2%? Explain.

c. What would the nominal interest rate be if the expected

inflation rate were −6%? Explain.

d. What would a negative nominal interest rate mean for

lenders? How much lending would take place at a negative

nominal interest rate? Explain.

e. What effect does a nominal interest rate of zero have on

monetary policy? What is this situation called?

Quantity of

loanable funds

Nominal

interest

rate, r

E 10

E 0

S 10

D 10

S 0

D 0

14%

4

0 Q*

Supply of loanable

funds at 0%

expected inflation

Demand for loanable funds

at 0% expected inflation

Supply of loanable funds

at 10% expected inflation

Demand for loanable funds

at 10% expected inflation

Answer (8 points)

1 point:Vertical axis labeled “Inflation rate”

1 point:Horizontal axis labeled “Unemployment rate”

1 point:Downward sloping curve labeled “SRPC 0 ”

1 point:Vertical curve labeled “LRPC”

1 point:SRPC 0 crosses horizontal axis where it crosses LRPC

1 point:NAIRUis labeled where SRPC 0 crossesLRPCand horizontal axis

1 point:NewSRPCis labeled, for example as “SRAS’”,and shown above the
originalSRPC 0

1 point:When the unemployment rate moves below the NAIRU,it creates
inflation and moves the economy to a point such as A. This leads to positive
inflationary expectations, which shift the SRPCup as shown by SRPC'.

8%

7 6 5 4 3 2 1 0

–1

–2

–3

Inflation
rate

8%76543

Unemployment rate

SRPC 0

SRPC’

Long-run Phillips

curve, LRPC

E 0

A

Nonaccelerating inflation

rate of unemployment, NAIRU