AP_Krugman_Textbook

borrows the $900 will keep $450 in cash and deposit

$450 in the bank. The bank will lend out $450 ×0.9=

$405. Whoever borrows the $405 will keep $202.50 in

cash and deposit $202.50 in the bank. The bank will lend

out $202.50 ×0.9=$182.25, and so on. Overall this

leads to an increase in deposits of $1,000 +$450+

$202.50+... But it decreases the amount of currency in

circulation: the amount of cash is reduced by the $1,000

Silas puts into the bank. This is offset, but not fully, by

the amount of cash held by each borrower. The amount

of currency in circulation therefore changes by −$1,000 +

$450+$202.50+... The money supply therefore

increases by the sum of the increase in deposits and the

change in currency in circulation, which is $1,000 −

$1,000 +$450+$450+$202.50+$202.50+... and

so on.

Tackle the Test:

Multiple-Choice Questions

1. d


2. a


3. e


4. c


5. d

Tackle the Test:

Free-Response Questions

2. a.The bank must hold $5,000 as required reserves (5% of
   $100,000). It is holding $10,000, so $5,000 must be
   excess reserves.
   b.The bank must hold an additional $50 as reserves
   because that is the reserve requirement multiplied by the
   deposit: 5% of $1,000. The bank can lend out $950.
   c.The money multiplier is 1/0.05 =20. An increase of
   $2,000 in excess reserves can increase the money supply
   by $2,000 × 20 =$40,000.

Module 26

Check Your Understanding

1. The Panic of 1907, the S&L crisis, and the crisis of 2008
   all involved losses by financial institutions that were less
   regulated than banks. In the crises of 1907 and 2008,
   there was a widespread loss of confidence in the financial
   sector and collapse of credit markets. Like the crisis of
   1907 and the S&L crisis, the crisis of 2008 exerted a pow-
   erful negative effect on the economy.


2. The creation of the Federal Reserve failed to prevent bank
   runs because it did not eradicate the fears of depositors
   that a bank collapse would cause them to lose their
   money. The bank run eventually stopped after federal
   deposit insurance was instituted and the public came to
   understand that their deposits were protected.


3. The balance sheet effect occurs when asset sales cause
   declines in asset prices, which then reduce the value of
   other firms’ net worth as the value of the assets on their
   balance sheets declines. In the vicious cycle of deleveraging,
   the balance sheet effect on firms forces their creditors to
   call in their loan contracts, forcing the firms to sell assets

to pay back their loans, leading to further asset sales and

price declines. Because the vicious cycle of deleveraging

occurs across different firms and no single firm can stop it,

it is necessary for the government to step in to stop it.

Tackle the Test:

Multiple-Choice Questions

1. a


2. a


3. b


4. d


5. e

Tackle the Test:

Free-Response Questions

2. a.oversee the Federal Reserve System and serve on the
   Federal Open Market Committee
   b. 7
   c.the president of the United States
   d.14-year terms
   e.to insulate appointees from political pressure
   f.4 years; may be reappointed

Module 27

Check Your Understanding

1. An open-market purchase of $100 million by the Fed
   increases banks’ reserves by $100 million as the Fed cred-
   its their accounts with additional reserves. In other
   words, this open-market purchase increases the monetary
   base (currency in circulation plus bank reserves) by $100
   million. Banks lend out the additional $100 million.
   Whoever borrows the money puts it back into the bank-
   ing system in the form of deposits. Of these deposits,
   banks lend out $100 million ×(1−rr)= $100 million ×
   0.9=$90 million. Whoever borrows the money deposits
   it back into the banking system. And banks lend out $90
   million×0.9=$81 million, and so on. As a result, bank
   deposits increased by $100 million +$90 million +$81
   million+... =$100 million/rr=$100 million/0.1 =
   $1,000 million =$1 billion. Since in this simplified
   example all money lent out is deposited back into the
   banking system, there is no increase of currency in circu-
   lation, so the increase in bank deposits is equal to the
   increase in the money supply. In other words, the money
   supply increases by $1 billion. This is greater than the
   increase in the monetary base by a factor of 10: in this
   simplified model in which deposits are the only compo-
   nent of the money supply and in which banks hold no
   excess reserves, the money multiplier is 1/rr=10.

Tackle the Test:

Multiple-Choice Questions

1. d


2. e


3. d


4. b


5. c

SOLUTIONS TO AP REVIEW QUESTIONS S-15