76
ECON110B
V. Expectations, output and policy
•
Major implications: expectations of both future output
and future interest rates affect current spending and
therefore current output
•
Monetary policy
 How the effects of monetary policy depend crucially on
how expectations respond to policy

Δ
Monetary policy
⇒
Δ
Shortterm interest rate
⇒
What happens to spending and output depends on
how changes in the shortterm interest rate lead people
and firms to change their expectations of future
interest rates and future income
•
Fiscal policy
 The role of expectations: different story
1. Expectations and decisions: Taking stock
1) Expectations, consumption, and investment decisions
a. The channels through which expectations affect
consumption and investment spending
77
i) An increase in current and expected future aftertax
real labor income, or a decrease in current and expected
future real interest rates, increases human wealth and
leads to an increase in consumption
ii) An increase in current and expected future real
dividends, or a decrease in current and expected future
real interest rates, increases stock prices which leads
to an increase in nonhuman wealth and an increase in
consumption
iii) A decrease in current and expected future nominal
interest rates leads to an increase in bond prices,
which leads to an increase in nonhuman wealth and
an increase in consumption
iv) An increase in current and expected future real after
tax profits, or a decrease in current and expected
future real interest rates, increases the present value of
real aftertax profits, which leads to an increase in
investment
b. Expectations affect consumption and investment
decisions, both
directly and through asset prices
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Expectations and spending: the channels
2) Expectations and the
IS
relation
a. Major simplification
 Only two periods: the present and the future (all future
years lumped together)
b. Aggregate private spending (private spending)

The sum of consumption and investment

)
,
(
)
(
)
,
,
(
r
Y
I
T
Y
C
r
T
Y
A
+
−
≡

IS
relation:
G
r
T
Y
A
Y
+
=
−
−
+
)
,
,
(
c. Extension:
to take into account the role of expectations
 To allow spending to depend not only on current
variables but also on their expected values in the future
period
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G
r
T
Y
r
T
Y
A
Y
e
e
e
+
=
−
−
+
−
−
+
)
'
,
'
,
'
,
,
,
(
 Primes denote future values, and
e’
s expected values

Y
or
Y
’e
increase
⇒
↑
A

T
or
T
’e
increase
⇒
↓
A

r
or
r
’e
increase
⇒
↓
A
d. New
IS
curve
Graph V – 1: The New
IS
curve