AP_Krugman_Textbook

2. There is no long-run trade-off between inflation and
   unemployment because after expectations of inflation
   change, wages will adjust to the change, returning
   employment and the unemployment rate to their equilib-
   rium (natural) levels. This implies that once expectations
   of inflation fully adjust to any change in actual inflation,
   the unemployment rate will return to the natural rate of
   unemployment, or NAIRU. This also implies that the
   long-run Phillips curve is vertical.


3. Disinflation is costly because to reduce the inflation rate,
   aggregate output in the short run must typically fall below
   potential output. This, in turn, results in an increase in the
   unemployment rate above the natural rate. In general, we
   would observe a reduction in real GDP. The costs of disin-
   flation can be reduced by not allowing inflation to increase
   in the first place. The costs of any disinflation will also be
   lower if the central bank is credible and it announces in
   advance its policy to reduce inflation. In this situation, the
   adjustment to the disinflationary policy will be more rapid,
   resulting in a smaller loss of aggregate output.


4. If the nominal interest rate is negative, an individual is
   better off simply holding cash, which has a 0% nominal
   rate of return. If the options facing an individual are to
   lend and receive a negative nominal interest rate or to
   hold cash and receive a 0% nominal rate of return, the
   individual will hold cash. Such a scenario creates the pos-
   sibility of a liquidity trap, in which monetary policy is
   ineffective because the nominal interest rate cannot fall
   below zero. Once the nominal interest rate falls to zero,
   further increases in the money supply will lead firms and
   individuals to simply hold the additional cash.
   Tackle the Test:
   Multiple-Choice Questions


5. b


6. c


7. b


8. e


9. e
   Tackle the Test:
   Free-Response Questions


10. a.4%
    b.2%, because 4% −2% =2%
    c.0%, because although 4% −6% =−2%, nominal interest
    rates can’t go below zero
    d.Lenders would effectively have to pay people to borrow
    money, in that what the lenders received back would be

Inflation

rate

E 2

E 1

SRPC

46%

Unemployment rate

0

2%

2. Yes, there can still be an inflation tax because the tax is
   levied on people who hold money. As long as people hold
   money, regardless of whether prices are indexed or not,
   the government is able to use seignorage to capture real
   resources from the public.

Tackle the Test:

Multiple-Choice Questions

1. d


2. b


3. b


4. c


5. a

Tackle the Test:

Free-Response Question

Module 34

Check Your Understanding

1. When real GDP equals potential output, cyclical unem-
   ployment is zero and the unemployment rate is equal
   to the natural rate. This is the case at point E 1 in the
   figure assuming a natural rate of 6%. Any unemploy-
   ment in excess of this 6% rate represents cyclical unem-
   ployment. An increase in aggregate demand leads to a
   fall in the unemployment rate below the natural rate
   (negative cyclical unemployment) and an increase in
   the inflation rate. This is given by the movement from
   E 1 to E 2 in the figure and traces a movement upward
   along the short-run Phillips curve. A reduction in aggre-
   gate demand leads to a rise in the unemployment rate
   above the natural rate (positive cyclical unemployment)
   and a fall in the inflation rate. This would be repre -
   sented by a movement down along the short-run
   Phillips curve from point E 1. So for a given expected
   inflation rate, the short-run Phillips curve illustrates the
   relationship between cyclical unemployment and the
   actual inflation rate.

YP Real GDP

Aggregate

price

level

P 1

P 2

Potential

output

E 2

AD 2

LRAS

E 1

AD 1

S-20 SOLUTIONS TO AP REVIEW QUESTIONS