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1. In 1982, Congress and the Reagan administration enacted a series of tax reform measures that slashed the highest marginal personal income tax rate from nearly 60% to 29%. A. Using the dynamic AD-SAS-LAS model with normally sloped curves, show what effect this tax cut would have on equilibrium income and inflation. (3 points.) Some economists believe that marginal tax rates have an important effect on the supply of labor. They argue that higher marginal taxes cause people to want to work less and that lower marginal taxes cause people to want to work more. This argument was featured prominently in the debate over the Reagan tax cut proposals. Assuming this analysis is correct, consider how this effect alters the macroeconomic analysis of tax changes. B. Using the 4-quadrant diagram to derive the SAS curve, show how a tax cut affects the short-run aggregate supply curve. (4 points.) C. Using the 4-quadrant diagram to derive the SAS curve, show how a tax cut affects the long-run aggregate supply curve. (3 points.) D. Using the dynamic AD-SAS-LAS model with normally sloped curves, show what the short-run effect of this tax cut is on equilibrium output and inflation. (4 points.) E. How does your answer differ from the case without the labor supply effect? (3 points.) F. Using the dynamic AD-SAS-LAS model with normally sloped curves, show what the long-run effect of this tax cut is on equilibrium output and inflation. (4 points.) G. How does your answer differ from the case without the labor supply effect? (3 points.) 2. After 2 decades with inflation rates that were significantly above, and economic growth rates that were significantly below, the average of the other OECD (Organization of Economic Cooperation and Development) countries, the New Zealand government adopted a very strict form of inflation targeting in 1990. The main provision for monetary policy, contained in the Reserve Bank Act of 1989, specifies that the prime function of the Reserve Bank of New Zealand is to “maintain stability in the general level of prices.” The act mandates that the Minister of Finance and the Governor of the Reserve Bank agree on monetary policy targets to achieve price stability. Price stability is defined as an inflation rate of 2 percent. The Reserve Bank is free to choose the strategy that it believes will best achieve the policy target. If inflation is not kept at its target, the Reserve Bank Governor is subject to dismissal. Suppose that the New Zealand economy is currently at its natural real GDP and inflation is at 2%. Using the dynamic AD-SAS-LAS and IS-LM models with normally sloped curves clearly show what the Reserve Bank of New Zealand would do and what would happen to equilibrium income, inflation, and the real interest rate under the following circumstances. A. A millennium virus shuts down nearly every computer in the country. (4 points.) B. There is an inexplicable collapse of consumer confidence. (4 points.) C. Oil prices collapse. (4 points.) Now suppose that, following a series of deep, prolonged recessions, a new President promises to get the economy moving again. Working with Parliament, the new administration changes the Reserve Bank Act to charge the Reserve Bank of New Zealand with maintaining output and unemployment at their natural rates. Suppose that the New Zealand economy is currently at its natural real GDP and inflation is at 2%. Using the dynamic AD-SAS-LAS and IS-LM models with normally sloped curves, show what the Reserve Bank of New Zealand would do and what would happen to equilibrium income, inflation, and the real interest rate under the following circumstances. D. A millennium virus shuts down nearly every computer in the country. (4 points.) E. There is an inexplicable collapse of consumer confidence. (4 points.) F. Oil prices collapse. (4 points.) 3. You have just been appointed Chair of the Council of Economic Advisors for the newly elected President. The new President recognizes that the best chance for the enactment of her aggressive non-economic policy agenda is for the economy to be managed in order to keep output and employment at their natural levels and inflation under control. However, she has no training in economics and needs a basic tutorial on stabilization policy. She has asked you to provide short but illuminating answers to the following questions. A. What do discretionary policy activists believe about the economy? (3 points.) B. What do rules-based policy advocates believe about the economy? (3 points.) C. What is meant by multiplier uncertainty? (3 points.) D. Why does multiplier uncertainty exist? (3 points.) E. Why does multiplier uncertainty make stabilization policy more difficult? (3 points.) F. Is multiplier uncertainty more of a problem for discretionary policy or rules based policy? Why? (3 points.) G. What is meant by time lags? (3 points.) H. What problems do long and variable lags present to policymakers? (3 points.) 4. Using the dynamic AD-SAS-LAS and IS-LM models with normally shaped curves, A. Clearly show a consistent economic explanation for the change between Year 1 and Year 2. (12 points.) B. Clearly show a consistent economic explanation for the movement between Year 2 and Year 3. (12 points.) Structural Budget Deficit Real Money Supply Real Interest Rate Real GDP Output Ratio UnemInflation ployment Rate Rate Year 1 -$100 $50 5% $5,000 100% 3% 5% Year 2 -$125 $75 5% $5,500 105% 5% 3% Year 3 -$125 $50 10% $4,800 95% 10% 8% 5. BONUS QUESTION: Who won the 1999 Nobel Memorial Prize in Economic Science? (5 points.)