AP_Krugman_Textbook

module 45 Putting It All Together 451

Section 8 The Open Economy: International Trade and Finance

2. What is the effect of Mexico’s falling income on the demand for
   money and the nominal interest rate in Mexico?
   Demand for money Nominal interest rate
   a. increases decreases
   b. decreases decreases
   c. increases increases
   d. decreases increases
   e. increases unchanged


3. If the aggregate price level in Mexico decreases, what will
   happen to the real interest rate?
   a. It will increase.
   b. It will decrease.
   c. It will be unchanged.
   d. It will stabilize.
   e. It cannot be determined.


4. Suppose the aggregateprice level in Mexico decreases relative
   to that in the United States. What is the effect of this price

level change on the demand and on the exchange rate, for

Mexican pesos?

Demand for pesos Exchange rate

a. increases appreciates

b. increases depreciates

c. decreases appreciates

d. decreases depreciates

e. decreases is unchanged

5. If the Mexican government pursues expansionary fiscal
   policy in response to the recession, what will happen to
   aggregate demand and aggregate supply in the short-run?
   Aggregate demand Short-run aggregate supply
   a. increase increase
   b. increase decrease
   c. decrease increase
   d. decrease decrease
   e. increase no change

Tackle the Test: Free-Response Questions

1. Suppose the U.S. economy is experiencing a recession.
   a. Draw a correctly labeled aggregate demand-aggregate
   supply graph showing the aggregate demand, short-run
   aggregate supply, long-run aggregate supply, equilibrium
   output, and aggregate price level.
   b. Assume that energy prices increase in the United States.
   Show the effects of this increase on the equilibrium in your
   graph from part a.
   c. According to your graph, how does the increase in energy
   prices affect unemployment and inflation in the economy?
   d. Assume the United States and Canada are the only two
   countries in an open economy and that energy prices have
   remained unchanged in Canada. Draw a correctly labeled
   graph of the foreign exchange market for U.S. dollars, and
   use it to show the effect of increased U.S. energy prices on
   the demand for U.S. dollars. Explain.

Answer (12 points)

1 point:The vertical axis is labeled “Aggregate price level” and the horizontal
axis is labeled “Aggregate output” or “Real GDP.”

1 point:TheADcurve slopes downward, the SRAScurve slopes upward, and
theLRAScurve is vertical.

Y 2 Y 1 YP

P 1

P 2

SRAS 1

LRAS

AD

Real GDP

Aggregate
price
level
SRAS 2

1 point:The equilibrium is found where the SRAScurve crosses the AD

curve, and the equilibrium aggregate price level and aggregate output are

shown on the axes at this point.

1 point:The equilibrium is to the left of the LRAScurve.

1 point:TheSRAScurve shifts to the left.

1 point:The equilibrium aggregate price level and output are shown on the

axes at the new equilibrium (increased aggregate price level, decreased

aggregate output).

1 point:It increases unemployment.

1 point:It increases the aggregate price level (inflation).

1 point:The vertical axis is labeled “Exchange rate (Canadian dollars per U.S.

dollar),” horizontal axis is labeled “Quantity of U.S. dollars.” Demand for U.S.

dollars slopes downward and is labeled, supply of U.S. dollars slopes upward

and is labeled.

1 point:The equilibrium exchange rate and quantity of U.S. dollars are shown

on the axes at the intersection of the demand and supply curves.

1 point:The demand for U.S. dollars will decrease.

1 point:The inflation in the United States will lead to a decrease in the

demand for U.S. exports (which must be purchased with U.S. dollars).

Exchange rate

(Canadian dollars

per U.S. dollar)

E 1

E 2

Supply of

U.S. dollars

D 2

D 1

XR 2

XR 1

Q 2 Q 1

Quantity of U.S. dollars