AP_Krugman_Textbook

b.This is an expansionary fiscal policy because it is an

increase in government transfers that will increase dis-

posable income.

c.This is a contractionary fiscal policy because it is an

increase in taxes, which will reduce disposable income.

2. Federal disaster relief that is quickly disbursed is more
   effective at stabilizing the economy than legislated aid
   because there is very little time lag between the time of
   the disaster and the time when relief is received by vic-
   tims. In contrast, the process of creating new legislation is
   relatively slow, so legislated aid is likely to entail a time lag
   in its disbursement, potentially destabilizing the economy.


3. a.An economy is overstimulated when an inflationary gap is
   present. This will arise if an expansionary monetary or fis-
   cal policy is implemented when the economy is currently
   in long - run macroeconomic equilibrium. This shifts the
   aggregate demand curve to the right, in the short run rais-
   ing the aggregate price level and aggregate output and cre-
   ating an inflationary gap. Eventually, nominal wages will
   rise and shift the short - run aggregate supply curve to the
   left, and aggregate output will fall back to potential out-
   put. This is the scenario envisaged by the speaker.
   b.No, this is not a valid argument. When the economy is not
   currently in long - run macroeconomic equilibrium, an
   expansionary monetary or fiscal policy does not lead to the
   outcome described above. Suppose a negative demand
   shock has shifted the aggregate demand curve to the left,
   resulting in a recessionary gap. An expansionary monetary
   or fiscal policy can shift the aggregate demand curve back
   to its original position in long -run macroeconomic equilib-
   rium. In this way, the short- run fall in aggregate output
   and deflation caused by the original negative demand
   shock can be avoided. So, if used in response to demand
   shocks, fiscal or monetary policy is an effective policy tool.

Tackle the Test:

Multiple-Choice Questions

1. e


2. e


3. b


4. b


5. a

Tackle the Test:

Free-Response Questions

2. a.

b.Expansionary

Real GDP

Aggregate

price

level

YE YP

LRAS SRAS

AD

E

PE

shock, the aggregate price level rises and aggregate

output falls.

b.Increased investment spending shifts the aggregate

demand curve to the right. As a result of this positive

demand shock, both the aggregate price level and aggre-

gate output rise.

c.An increase in taxes and a reduction in government

spending both result in negative demand shocks, shifting

the aggregate demand curve to the left. As a result, both

the aggregate price level and aggregate output fall.

d.This is a negative supply shock, shifting the short - run

aggregate supply curve to the left. As a result, the aggre-

gate price level rises and aggregate output falls.

2. As long - run growth increases potential output, the long -
   run aggregate supply curve shifts to the right. If, in the
   short run, there is now a recessionary gap (aggregate out-
   put is less than potential output), nominal wages will
   fall, shifting the short - run aggregate supply curve to the
   right. This results in a fall in the aggregate price level and
   a rise in aggregate output. As prices fall, we move along
   the aggregate demand curve due to the wealth and inter-
   est rate effects of a change in the aggregate price level.
   Eventually, as long - run macroeconomic equilibrium is
   reestablished, aggregate output will rise to be equal to
   potential output, and the aggregate price level will fall to
   the level that equates the quantity of aggregate output
   demanded with potential output.

Tackle the Test:

Multiple-Choice Questions

1. c


2. a


3. d


4. b


5. b

Tackle the Test:

Free-Response Question

Module 20

Check Your Understanding

1. a.This is a contractionary fiscal policy because it is a reduc-
   tion in government purchases of goods and services.

Long-run

macroeconomic

equilibrium

Potential

output

ELR

YP

LRAS

SRAS

AD

Real GDP

Aggregate

price

level

PE

S-12 SOLUTIONS TO AP REVIEW QUESTIONS