AP_Krugman_Textbook

c.Decrease taxes, increase government purchases of goods

and services, or increase government transfers

Module 21

Check Your Understanding

1. A $500 million increase in government purchases of
   goods and services directly increases aggregate spending
   by $500 million, which then starts the multiplier in
   motion. It will increase real GDP by $500 million ×
   1/(1−MPC). A $500 million increase in government
   transfers increases aggregate spending only to the extent
   that it leads to an increase in consumer spending.
   Consumer spending rises by MPC×$1 for every $1
   increase in disposable income, where MPCis less than 1.
   So a $500 million increase in government transfers will
   cause a rise in real GDP only MPCtimes as much as a
   $500 million increase in government purchases of goods
   and services. It will increase real GDP by $500 million ×
   MPC/(1−MPC).


2. If government purchases of goods and services fall by
   $500 million, the initial fall in aggregate spending is
   $500 million. If there is a $500 million tax increase, the
   initial fall in aggregate spending is MPC×$500 million,
   which is less than $500 million because some of the tax
   payments are made with money that would otherwise
   have been saved rather than spent.


3. Boldovia will experience greater variation in its real GDP
   than Moldovia because Moldovia has automatic stabiliz-
   ers while Boldovia does not. In Moldovia the effects of
   slumps will be lessened by unemployment insurance ben-
   efits, which will support residents’ incomes, while the
   effects of booms will be diminished because tax revenues
   will go up. In contrast, incomes will not be supported in
   Boldovia during slumps because there is no unemploy-
   ment insurance. In addition, because Boldovia has lump-
   sum taxes, its booms will not be diminished by increases
   in tax revenue.

Tackle the Test:

Multiple-Choice Questions

1. c


2. b


3. b


4. c


5. e

Tackle the Test:

Free-Response Questions

2. a.$50 million
   multiplier=1/(1−MPC)=1/(1−0.75)=1/0.25= 4
   change in G × 4 =$200 million
   change in G =$50 million
   b. 10
   $20×multiplier=$200 million
   multiplier=200/20= 10
   c.0.1
   1/(1−MPC)=1/MPS= 10
   MPS=0.1

Module 22

Check Your Understanding

1. The transaction costs for (a) a bank deposit and (b) a
   share of a mutual fund are approximately equivalent
   because each can typically be accomplished by making a
   phone call, going online, or visiting a branch office.
   Transaction costs are highest for (c) a share of a family
   business since finding a buyer for the share consumes time
   and resources. The level of risk is lowest for (a) a bank
   deposit, since these deposits are insured by the Federal
   Deposit Insurance Corporation (FDIC) up to $250,000;
   somewhat higher for (b) a share of a mutual fund since
   despite diversification, there is still risk associated with
   holding stocks; and highest for (c) a share of a family busi-
   ness since this investment is not diversified. The level of
   liquidity is the lowest for (c) a share of a family business,
   since it can be sold only with the unanimous agreement of
   other members and it will take some time to find a buyer;
   higher for (b) a share of a mutual fund, since it will take
   only a few days between selling your shares and the pay-
   ment being processed; and highest for (a) a bank deposit,
   since withdrawals can usually be made immediately.


2. Economic development and growth are the result of, among
   other factors, investment spending on physical capital.
   Since investment spending is equal to savings, the greater
   the amount saved, the higher investment spending will be,
   and so the higher growth and economic development will
   be. So the existence of institutions that facilitate savings
   will help a country’s growth and economic development. As
   a result, a country with a financial system that provides low
   transaction costs, opportunities for diversification of risk,
   and high liquidity to its savers will experience faster growth
   and economic development than a country that doesn’t.
   Tackle the Test:
   Multiple-Choice Questions


3. d


4. e


5. a


6. d


7. b
   Tackle the Test:
   Free-Response Questions


8. Mutual fund–a financial intermediary that creates a
   stock portfolio by buying and holding shares in compa-
   nies and then selling shares of the stock portfolioto indi-
   vidual investors.
   Life insurance company–a firm that guarantees a
   payment to the policyholder’s beneficiaries (typically, the
   family) when the policyholder dies.
   Bank–an institution that helps resolve the conflict
   between lenders’ needs for liquidity and the illiquid
   financing needs of borrowers who don’t want to use the
   stock or bond markets.
   Pension fund–a nonprofit institution that collects the
   savings of its members and invests those funds in a vari-
   ety of assets, providing its members with income when
   they retire.

SOLUTIONS TO AP REVIEW QUESTIONS S-13