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