17: Chapter Expectations, Output, and Policy
Since C, consumption, depends on total wealth (expected labor income and nonhuman-wealth), and since I, investment, depends on expected profits, we examine the IS-LM story with expectations.
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Expectations, Consumption, and Investment Decisions
Consumption and investment depend on expectations of the future. To take into account the effect of expectations, we do the following: Earlier, the IS relation was:
Chapter 17: Expectations, Output, and Policy
Y = C (Y T ) + I (Y ,r ) + G
Define aggregate private spending or simply, private spending, A, as:
A (Y ,T ,r ) C (Y T ) + I (Y ,r )
Rewrite the IS relation as:
Y = A ( Y ,T ,r ) + G
(+ , , )
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Expectations and the IS Relation
Chapter 17: Expectations, Output, and Policy
Given Y = C ( Y T ) + I ( Y , r ) + G
and Y = A ( Y , T , r ) + G
(+ , , )
and incorporating the role of expectations, then: Y = A (Y , T , r , Y 'e , T 'e r 'e ) + G
( + , , + , , )
* Primes denote future values, and es expected values.
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Expectations and the IS Relation
Chapter 17: Expectations, Output, and Policy
Figure 17 - 2
The New IS Curve
Given expectations, a decrease in the real interest rate leads to a small increase in output: The IS curve is steeply downward sloping. Increases in government spending, or in expected future output, shift the IS curve to the right. Increases in taxes, in 2006 Prentice Hall Business Publishing expected future
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Expectations and the IS Relation
Chapter 17: Expectations, Output, and Policy
The new IS curve is steep, which means that a large decrease in the current interest rate is likely to have only a small effect on equilibrium income, for two reasons: A decrease in the current real interest rate does not have much effect on spending if future expected rates are not likely to be lower as well. The multiplier is likely to be small. If changes in income are not expected to last, they will have a limited effect on consumption and investment.
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Expectations and the IS Relation
Chapter 17: Expectations, Output, and Policy
Changes in Y
= A ( Y , T , r , Y ' e ,T ' e r ' e ) + G ( + , , + , , )
other than Y and r, shift the IS curve: Changes in T (current taxes) or G (current government spending) shift the IS curve Changes in expected future variables also shift the IS curve.
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The LM Relation Revisited
Chapter 17: Expectations, Output, and Policy
The LM relation is not modified because the opportunity cost of holding money today depends on the current nominal interest rate, not on the expected nominal interest rate one year from now.
M = Y L (i) P
The interest rate that enters the LM relation is the current nominal interest rate.
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17-2
Monetary Policy, Expectations, and Output
Chapter 17: Expectations, Output, and Policy
When the Fed expanded the money supply, the interest rate went down, and spending increased. There are many interest rates, keep these two distinctions in mind: The distinction between the nominal interest rate and the real interest rate. The distinction between current and expected future interest rates.
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Monetary Policy, Expectations, and Output
Lets look at this distinction more closely: The interest rate is approximately equal to the nominal interest rate minus expected current inflation: e
Chapter 17: Expectations, Output, and Policy
r = i
e e
The expected future real interest rate is approximately equal to the expected future nominal interest rate minus expected future inflation:
r ' = i' '
e
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Monetary Policy, Expectations, and Output
Decreasing the current nominal interest rate i effects the current and expected future real interest rates depending on two factors: Whether the increase in the money supply leads financial markets to revise their expectations of the future nominal interest rate, ie. Whether the increase in the money supply leads financial markets to revise their expectations of both current and future inflation e and e.
Chapter 17: Expectations, Output, and Policy
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Monetary Policy, Expectations, and Output
Figure 17 - 3
The New IS-LM
Chapter 17: Expectations, Output, and Policy
The IS curve is steeply downward sloping: Other things a equal, change in the current interest rate has a small effect on output. The LM curve is upward sloping. The equilibrium I S : is at theY , T , r , Y ' e , T ' e Y = A( intersection of 2006 Prentice Hall Business Publishing the IS and LM
,r' ) + G
e
M LM : = Y L (r ) P
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Monetary Policy Revisited
Chapter 17: Expectations, Output, and Policy
Figure 17 - 4
The Effects of an Expansionary Monetary Policy
The effects of monetary policy on output depend very much on whether and how monetary policy affects expectations.
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Monetary Policy, Expectations, and Output
The effects of monetary policy depend crucially on its effect on expectations: If a monetary expansion leads financial investors, firms, and consumers to revise their expectations of future interest rates and output, then the effects of the monetary expansion on output may be very large. But if expectations remain unchanged, the effects of the monetary expansion on output will be small.
Chapter 17: Expectations, Output, and Policy
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Monetary Policy, Expectations, and Output
Economists refer to expectations formed in a forward-looking manner as rational expectations: People form expectations about the future by assessing the likely course of future expected policy and then working out the implications of future activity.
Chapter 17: Expectations, Output, and Policy
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17-3
Deficit Reduction, Expectations, and Output
Chapter 17: Expectations, Output, and Policy
In the short run, deficit reduction leads to a decrease in output. In the medium run, deficit reduction has no effect on output, but leads to a lower interest rate and higher investment. In the long run, higher investment leads to a higher capital stock, and thus a higher level of output.
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The Role of Expectations About the Future
Lets review what we learned about the effects of a deficit reduction in the medium run and the long run: In the medium run, a deficit reduction has no effect on output. It leads, however, to a lower interest rate and to higher investment. In the long run, higher investment leads to a higher capital stock, and to a higher level of output.
Chapter 17: Expectations, Output, and Policy
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Back to the Current Period
Chapter 17: Expectations, Output, and Policy
Deficit reduction may actually increase spending and output, even in the short run, if people take into account the future beneficial effects of deficit reduction. In response to the announcement of deficit reduction, Current spending goes downthe IS curve shifts to the left. Expected future output goes upthe IS curve shifts to the right. And the interest rate goes downthe IS curve shifts to the right.
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Back to the Current Period
Chapter 17: Expectations, Output, and Policy
Figure 17 - 5
The Effects of a Deficit Reduction on Current Output
When account is taken of its effect on expectations, the decrease in government spending need not lead to a decrease in output.
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Back to the Current Period
Small cuts in government spending and large expected cuts in the future will cause output to increase more in the current perioda concept known as backloading. Backloading, however, may lead to a problem with the credibility of the deficit reduction programleaving most of the reduction for the future, not the present. The government must play a delicate balancing act: enough cuts in the current period to show a commitment to deficit reduction and enough cuts left to the future to reduce the adverse effects on the economy in the short run.
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Chapter 17: Expectations, Output, and Policy
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Can a Bu dge t Def icit Reduction Lead to an Output Expans ion? Ire la nd in the 1 980 s
Chapter 17: Expectations, Output, and Policy
Ireland went through two major deficit reduction programs in the 1980s.
Table 1 Fiscal and Other Macroeconomic Indicators, Ireland, 1981-1984 and 19861989.
1981
1 Budget deficit (% of GDP) 2 Output growth rate (%) 3 Unemployment rate (%) 4 Household saving rate (% of disposable income)
1982 -13.4 2.3 11.0 19.6
1983 -11.4 -0.2 13.5 18.1
1984 -9.5 4.4 15.0 18.4
1986 -10.7 -0.4 17.1 15.7
1987 -8.6 4.7 16.9 12.9
1988 -4.5 5.2 16.3 11.0
1989 -1.8 5.8 15.1 12.6
-13.0 3.3 9.5 17.9
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