1. IS/LM Model with Budget Balance (50 Points.)

1. IS/LM Model with Budget Balance (50 points.)

In 1982, the Reagan Administration and Congress enacted a series of tax reform measures that slashed the highest marginal personal income tax rate from nearly 60% to 29%. Use a standard IS/LM model with a Budget Balance line and assume that all changes in either the IS, LM or BB curves can be represented by parallel shifts.

I. Start with an IS/LM diagram with an accompanying Budget Balance line.

(a) Show how this legislation would affect equilibrium income, the interest rate and the actual budget balance. (6 points.)

(b) Clearly label the amount of income that is being “crowded out”. (3 points.)

(d) What is the relevance of “crowding out”? That is, why does “crowding out” occur and what are its consequences? (6 points.)

(e) How would we measure the magnitude of this change in fiscal policy? Explain. (5 points.)

II. Now, following these tax reforms, suppose the Federal Reserve engaged in an accommodating monetary policy.

(f) Show how this would affect equilibrium income, the interest rate and the actual budget deficit. (6 points.)

(g) Under what economic circumstances would the Federal Reserve engage in this type of policy. (5 points.)

(h) How would the Federal Reserve actually go about changing the money supply? Be specific. (5 points.)

(i) What has happened to the structural budget balance because of this change in monetary policy. Explain. (5 points.)

(j) What has happened to the cyclical budget balance because of this change in monetary policy. Explain. (5 points.)

2. Money and Financial Markets (50 points.)

I. Basic Definitions.

(a) What is the money multiplier? (5 points.)

(b) What does the money multiplier depend on? (5 points.)

(d) Explain how the central bank would use each of these tools to decrease the supply of high-powered money? (6 points.)

II. Suppose that people hold currency in proportion to their bank deposits and that banks hold reserves in proportion to their deposits. During the holiday season, people choose to hold more of their money in the form of cash—and, therefore, less as bank deposits—to facilitate their holiday shopping.

(e) What component of the money multiplier does this affect? (3 points.)

(f) What effect does this shift have on the money supply? Explain. (5 points.)

(g) What specific monetary policy tool(s) would the central bank use, and how would they use it, if they wanted to offset this effect on the money supply? (5 points.)

III. Alternatively, suppose that a series of decisions by banks effectively raises the banking system’s holding of reserves.

(h) What component of the money multiplier does this affect? (3 points.)

(i) What effect does this decision have on the money supply? Explain. (5 points.)

(j) What specific monetary policy tool(s) would the central bank use, and how would they use it, if they wanted to offset this effect on the money supply? (5 points.)

IV. Finally, suppose that the interest rate is so low that banks refuse to make loans. Further, suppose that the central bank responds by increasing the supply of high-powered money. If all of the new high-powered money ends up as bank reserves, what happens to the money supply? Explain. (5 points.)

3. International Trade and Exchange Rates (50 points.)

Suppose that you have just been appointed Chief Economics minister of a small open economy with perfect capital mobility. It is your goal to keep equilibrium income at its natural level, where it currently is. Use a standard IS/LM/BP model of the economy, in which all changes in monetary and fiscal policy can be represented by parallel shifts in the IS and LM curves.

I. Start with a standard IS/LM/BP diagram.

(a) Show the initial effect of a decrease in world income on domestic income. HINT: Exports depend on world income. (5 points.)

(b) Explain the adjustment mechanism that would take place under a fixed exchange rate regime. That is, where would equilibrium income and the interest rate end up and why? (5 points.)

(c) Explain the adjustment mechanism that would take place under a flexible exchange rate regime. That is, where would equilibrium income and the interest rate end up and why? (5 points.)

(d) What policy would you implement to restore equilibrium income to its natural level under a fixed exchange rate regime? (5 points.)

(e) What policy would you implement to restore equilibrium income to its natural level under a flexible exchange rate regime? (5 points.)

II. Start with a new IS/LM/BP diagram.

(f) Show the initial effect of an increase in the world interest rate on domestic income. HINT: The BP line shows the world interest rate. (5 points.)

(g) Explain the adjustment mechanism that would take place under a fixed exchange rate regime. That is, where would equilibrium income and the interest rate end up and why? (5 points.)

(h) Explain the adjustment mechanism that would take place under a flexible exchange rate regime. That is, where would equilibrium income and the interest rate end up and why? (5 points.)

(i) What policy would you implement to restore equilibrium income to its natural level under a fixed exchange rate regime? (5 points.)

(j) What policy would you implement to restore equilibrium income to its natural level under a flexible exchange rate regime? (5 points.)