AP_Krugman_Textbook

3. a


4. d


5. b

Tackle the Test:

Free-Response Questions

2. The decrease in aggregate demand that occurs during a
   recession includes the demand for goods and services
   produced abroad as well as at home. When a trading
   partner experiences a recession, it leads to a fall in their
   imports. The trading partner’s imports are the country’s
   exports.
   A reduction in foreign demand for the country’s
   domestic goods and services leads to a reduction in
   demand for the domestic currency. With a floating
   exchange rate, the currency depreciates. This makes
   domestic goods and services cheaper, so exports
   don’t fall by as much as they would have, and it
   makes imports more expensive, leading to a fall in
   imports. Both effects limit the decline in domestic
   aggregate demand.

Module 45

Check Your Understanding

1. a.

b.Aggregate demand shifts left, real GDP and the aggregate

price level fall.

c.Nominal wages will decrease as a result of the reces-

sionary gap and the decrease in the aggregate price

level, leading to an increase in short-run aggregate

supply. The rightward shift in the short-run aggregate

supply curve moves the economy back to long-run

equilibrium at potential output and a lower aggregate

price level.

d.Lower government spending will decrease the govern-

ment budget deficit. With less borrowing by the gov-

ernment, the demand for loanable funds will

decrease, shifting the demand curve from D 1 to D 2

Y 2 Y 1

SRAS

LRAS

AD 1

Long-run

macroeconomic

equilibrium

Potential

output

Real GDP

Aggregate

price

level

ELR

E 2

AD 2

P 1

P 2

d.Imposing a tax on exports (Chinese goods sold to for-

eigners) would raise the price of these goods and decrease

the amount of Chinese goods purchased. This would also

decrease the demand for yuan with which to purchase

those goods. The graphical analysis here is virtually iden-

tical to that found in the figure accompanying part b.

Tackle the Test:

Multiple-Choice Questions

1. e


2. e


3. b


4. a


5. a

Tackle the Test:

Free-Response Questions

2. a.Use foreign exchange reserves. To stabilize an exchange
   rate through exchange market intervention (e.g., buying
   its own currency), a country must keep large quantities of
   foreign currency on hand, which is usually a low-return
   investment. And large reserves can be quickly exhausted
   when there are large capital flows out of a country.
   b.Shifting supply and demand curves for currency through
   monetary policy. If a country chooses to stabilize an
   exchange rate by adjusting monetary policy rather than
   through intervention, it must divert monetary policy
   from other goals, notably stabilizing the economy and
   managing the inflation rate.
   c.Foreign exchange controls. These regulations distort
   incentives for importing and exporting goods and servic-
   es. They can also create substantial costs in terms of red
   tape and corruption.

Module 44

Check Your Understanding

1. The devaluations and revaluations most likely occurred in
   those periods when there was a sudden change in the
   franc-mark exchange rate: 1974, 1976, the early 1980s,
   1986, and 1993–1994.


2. The high Canadian interest rates caused an increase in
   capital inflows to Canada. To obtain assets that yielded
   a relatively high interest rate in Canada, investors first
   had to obtain Canadian dollars. The increase in the
   demand for the Canadian dollar caused the Canadian
   dollar to appreciate. This appreciation of the Canadian
   currency raised the price of Canadian goods to foreign-
   ers (measured in terms of the foreign currency). This
   made it more difficult for Canadian firms to compete in
   other markets.

Tackle the Test:

Multiple-Choice Questions

1. c


2. b

S-26 SOLUTIONS TO AP REVIEW QUESTIONS