AP_Krugman_Textbook

2. We know from the loanable funds market that as the
   interest rate rises, households want to save more and con-
   sume less. But at the same time, an increase in the interest
   rate lowers the number of investment spending projects
   with returns at least as high as the interest rate. The state-
   ment “households will want to save more money than
   businesses will want to invest” cannot represent an equilib-
   rium in the loanable funds market because it says that the
   quantity of loanable funds offered exceeds the quantity of
   loanable funds demanded. If that were to occur, the inter-
   est rate would fall to make the quantity of loanable funds
   offered equal to the quantity of loanable funds demanded.


3. a.The real interest rate will not change. According to the
   Fisher effect, an increase in expected inflation drives up
   the nominal interest rate, leaving the real interest rate
   unchanged.
   b.The nominal interest rate will rise by 3%. Each additional
   percentage point of expected inflation drives up the nom-
   inal interest rate by 1 percentage point.
   c.As long as inflation is expected, it does not affect the
   equilibrium quantity of loanable funds. Both the supply
   and demand curves for loanable funds are pushed
   upward, leaving the equilibrium quantity of loanable
   funds unchanged.

Tackle the Test:

Multiple-Choice Questions

1. c


2. b


3. b


4. c


5. a

Tackle the Test:

Free-Response Questions

2. a.This causes an increase (rightward shift) in the supply of
   loanable funds.
   b.This causes a decrease (leftward shift) in the demand for
   loanable funds.
   c.This causes an increase (rightward shift) in the demand
   for loanable funds.
   d.This causes a decrease (leftward shift) in the supply of
   loanable funds.

Q 2 Q 1 Quantity of

loanable funds

r 2

r 1

Interest

rate, r

S 2

S 1

E 2

E 1

D

Module 30

Check Your Understanding

1. The actual budget balance takes into account the effects
   of the business cycle on the budget deficit. During reces-
   sionary gaps, it incorporates the effect of lower tax rev-
   enues and higher transfers on the budget balance; during
   inflationary gaps, it incorporates the effect of higher tax
   revenues and reduced transfers. In contrast the cyclically
   adjusted budget balance factors out the effects of the
   business cycle and assumes that real GDP is at potential
   output. Since, in the long run, real GDP tends to poten-
   tial output, the cyclically adjusted budget balance is a bet-
   ter measure of the long-run sustainability of government
   policies.


2. In recessions, real GDP falls. This implies that consumers’
   incomes, consumer spending, and producers’ profits also
   fall. So in recessions, states’ tax revenue (which depends
   in large part on consumers’ income, consumer spending,
   and producers’ profits) falls. In order to balance the state
   budget, states have to cut spending or raise taxes, but that
   deepens the recession. States without a balanced-budget
   requirement don’t have to take steps that would make
   things worse during a recession, and they can use expan-
   sionary fiscal policy to lessen the fall in real GDP.


3. a.A higher growth rate of real GDP implies that tax rev-
   enue will increase. If government spending remains con-
   stant and the government runs a budget surplus, the size
   of the public debt will be less than it would otherwise
   have been.
   b.If retirees live longer, the average age of the population
   increases. As a result, the implicit liabilities of the gov-
   ernment increase because spending on programs for
   older Americans, such as Social Security and Medicare,
   will rise.
   c.A decrease in tax revenue without offsetting reductions in
   government spending will cause the public debt to
   increase.
   d.Public debt will increase as a result of government bor-
   rowing to pay interest on its current public debt.


4. In order to stimulate the economy in the short run, the
   government can use fiscal policy to increase real GDP.
   This entails borrowing, increasing the size of public debt
   further and leading to undesirable consequences: in
   extreme cases, governments can be forced to default on
   their debts. Even in less extreme cases, a large public debt
   is undesirable because government borrowing “crowds
   out” borrowing for private investment spending. This
   reduces the amount of investment spending, reducing the
   long-run growth of the economy.

Tackle the Test:

Multiple-Choice Questions

1. b


2. d


3. c


4. d


5. e

SOLUTIONS TO AP REVIEW QUESTIONS S-17