AP_Krugman_Textbook

c.No change in aggregate supply; aggregate demand

increases. Lower interest rates lead to greater investment

spending (and more interest-sensitive consumer spend-

ing). Aggregate demand is made up of C+I+G+

(X−IM), so an increase in Iand Cincreases AD. Interest

rate changes don’t affect short-run aggregate supply.

d.As shown in the accompanying figure, aggregate output

increases in the short run.

Module 32

Check Your Understanding

1. A 5% increase in the money supply will cause a 5%
   increase in the aggregate price level in the long run. The
   process begins in the short run, when the larger money
   supply decreases the interest rate and promotes investment
   spending. Investment spending is a component of aggre-
   gate demand, so the increase in investment spending leads
   to an increase in aggregate demand, which causes real
   GDP to increase beyond potential output. The resulting
   upward pressure on nominal wages and other input prices
   shifts aggregate supply to the left until a new long-run
   equilibrium is reached. Although real GDP returns to its
   original level, both the increase in aggregate demand and
   the decrease in aggregate supply cause the aggregate price
   level to increase. The end result is 5% more money being
   spent on the same quantity of goods and services, which
   could only mean a 5% increase in the aggregate price level.


2. A 5% increase in the money supply will have no effect on
   the interest rate in the long run. As explained in the pre-
   vious answer, a 5% increase in the money supply is
   matched by a 5% increase in the aggregate price level in
   the long run. Changes in the aggregate price level, in turn,
   cause proportional changes in the demand for money. So
   a 5% increase in the aggregate price level increases the
   quantity of money demanded at any given interest rate by
   5%. This means that at the initial interest rate, the quan-
   tity of money demanded rises exactly as much as the
   money supply, and the new, long-run interest rate is
   therefore no different from the initial interest rate.

Real GDP

Aggregate

price

level

AD 2

SRAS 1

LRAS

AD 1

An increase in the money supply

reduces the interest rate and

increases aggregate demand.

Y 1 Y 2

E 1

E 2

Tackle the Test:

Multiple-Choice Questions

1. c


2. d


3. c


4. c


5. e
   Tackle the Test:
   Free-Response Questions


6. a.

b.The aggregate demand curve shifts to the right, creating a

new equilibrium price level and real GDP. The higher

money supply leads to a lower interest rate, which

increases investment spending and consumer spending,

and in turn aggregate demand.

c.Wages rise over time, shifting short-run aggregate supply

to the left. This brings equilibrium back to potential out-

put with a higher price level.

Module 33

Check Your Understanding

1. The inflation rate is more likely to quickly reflect changes
   in the money supply when the economy has had
   an extended period of high inflation. That’s because an
   extended period of high inflation sensitizes workers and
   firms to raise nominal wages and prices of intermediate
   goods when the aggregate price level rises. As a result,
   there will be little or no increase in real output in the
   short run after an increase in the money supply, and the
   increase in the money supply will simply be reflected in a
   proportional increase in prices. In an economy where
   people are not sensitized to high inflation because of low
   inflation in the past, an increase in the money supply
   will lead to an increase in real output in the short run.
   This illustrates the fact that the classical model of the
   price level best applies to economies with persistentlyhigh
   inflation, not those with little or no history of high infla-
   tion even though they may currently have high inflation.

YP Y 1 Real GDP

P 3

Aggregate

price

level

P 1

P 2

Potential

output

E 3

AD 2

SRAS 2

SRAS 1

LRAS

E 2

E 1

AD 1

SOLUTIONS TO AP REVIEW QUESTIONS S-19