AP_Krugman_Textbook

Exchange rate

(Canadian dollars

per U.S. dollar)

E 2

E 1

Supply of

U.S. dollars

D 1

D 2

XR 1

XR 2

Quantity of U.S. dollars

Module 45 AP Review

Check Your Understanding

1. The economy is operating in long-run macroeconomic
   equilibrium.
   a. Illustrate this situation using a correctly labeled aggregate
   demand-aggregate supply graph.
   b. Use your graph to show the short-run effect on real GDP
   and the aggregate price level if there is a decrease in
   government spending.

c. What will happen to the aggregate price level and real GDP

in the long run? Explain.

d. Suppose the government is experiencing a persistent budget

deficit. How will the decrease in government spending affect

that deficit? Use a correctly labeled graph of the loanable

funds market to show the effect of a decrease in government

spending on the interest rate.

Solutions appear at the back of the book.

Tackle the Test: Multiple-Choice Questions

Questions 1–5 refer to the following scenario:

The United States and Mexico are trading partners. Suppose a

flu outbreak significantly decreases U.S. tourism in Mexico and

causes the Mexican economy to enter a recession. Assume that

the money that would have been spent by U.S. tourists in

Mexico is, instead, not spent at all.

1. Which of the following occurs as a result of the recession in
   Mexico?
   I. Output in Mexico decreases.
   II. Aggregate demand in the United States decreases.
   III. Output in the United States decreases.
   a. I only
   b. II only
   c. III only
   d. I and II only
   e. I, II, and III

450 section 8 The Open Economy: International Trade and Finance

✔ What will happen to the U.S. dollar relative to the Canadian dollar?

The U.S. dollar will appreciate.

✔ How will the Federal Reserve’s contractionary monetary policy affect the real interest rate in the

United States? Explain.

There will be no effect on the real interest rate in the long run because, due to the neu-

trality of money, changes in the money supply do not affect real values in the long run.