AP_Krugman_Textbook

less than what they lent out. No lending would take

place. It is better to hold cash than to pay people to bor-

row money.

e.Conventional monetary policy (decreasing interest rates)

can’t happen if the nominal interest rate is already zero.

This is called the zero bound OR a liquidity trap.

Module 35

Check Your Understanding

1. A classical economist would have said that the aggressive
   monetary expansion would have had no short-run effect
   on aggregate output and would simply have resulted in a
   proportionate increase in the aggregate price level.


2. Monetarists argue that central banks should implement
   policy so that the money supply grows at some constant
   rate. Had the Fed pursued a monetarist policy during this
   period, we would have observed movements in M1 that
   would have shown a fixed rate of growth. We would not,
   therefore, have observed any of the reductions in M1 that
   are observed in the figure, nor would we have observed
   the acceleration in the rate of growth of M1 that
   occurred in 2001.


3. As in Problem 2, a monetarist policy would have resulted
   in a constant rate of growth in M1. Between 1996 and
   2000 the velocity of M1 rose steadily. After 2000 the
   velocity leveled off a bit and then rose again. Given a
   constant rate of money growth, these increases in the
   velocity of M1 would have been expansionary, causing
   increases in aggregate demand and the aggregate price
   level, other things equal.


4. The advocacy of fiscal policy (here in the form of tax cuts)
   to boost economic activity is Keynesian because Keynes pro-
   moted fiscal policy as a useful tool to dampen fluctuations
   in the business cycle. The praise of aggressive monetary pol-
   icy is not Keynesian because Keynes worried that a liquidity
   trap would thwart the ability of monetary policy to change
   interest rates and influence investment spending.


5. a.Rational expectations theorists would argue that only
   unexpected changes in money supply would have any
   short-run effect on economic activity. They would also
   argue that expected changes in the money supply would
   affect only the aggregate price level, with no short-run
   effect of aggregate output. So such theorists would give
   credit to the Fed for limiting the severity of the 2001
   recession only if the Fed’s monetary policy had been more
   aggressive than individuals expected during this period.
   b.Real business cycle theorists would argue that the Fed’s
   policy had no effect on ending the 2001 recession
   because they believe that fluctuations in aggregate output
   are caused largely by changes in total factor productivity.

Tackle the Test:

Multiple-Choice Questions

1. e


2. d


3. b


4. a


5. d

Tackle the Test:

Free-Response Questions

2. a.The aggregate supply curve is vertical so changes in the
   money supply affect only the aggregate price level.
   b.Changes in aggregate demand will affect aggregate out-
   put.
   c.Business cycles are associated with fluctuations in the
   money supply.
   d.To avoid inflation, the unemployment rate must be set so
   that actual inflation equals expected inflation.
   e.Individuals and firms make optimal decisions using all
   available information.
   f.Fluctuations in total factor productivity growth cause the
   business cycle by causing the vertical aggregate supply
   curve to shift.

Module 36

Check Your Understanding

1. The modern consensus has resolved the debate over the
   effectiveness of both expansionary fiscal and monetary
   policy. Expansionary fiscal policy is considered effective,
   although it is limited by the problem of time lags, making
   monetary policy the stabilization tool of choice except in
   special circumstances. Expansionary monetary policy is
   considered effective except in the case of a liquidity trap.
   The modern consensus has not resolved, however,
   whether the Fed should adopt an inflation target,
   whether it should use monetary policy to manage asset
   price bubbles, and what, if any, kind of unconventional
   monetary policy it should use in the situation of a liquid-
   ity trap.

Tackle the Test:

Multiple-Choice Questions

1. d
   2 .c


2. e


3. a


4. c

Tackle the Test:

Free-Response Question

2. Your answer can look like the diagram below, or it can
   have the axes reversed and a curve that resembles a
   mountain.

Tax

rate

Tax revenue

SOLUTIONS TO AP REVIEW QUESTIONS S-21