Download Fall 1999 Mid-Term Exam #2

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.)