76ECON110B 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 - ΔMonetary policy ⇒ΔShort-term interest rate ⇒What happens to spending and output depends on how changes in the short-term 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 77i) An increase in current and expected future after-tax 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 after-tax 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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78Expectations and spending: the channels 2) Expectations and the ISrelation 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- ),()(),,(rYITYCrTYA+−≡- ISrelation: GrTYAY+=−−+),,(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 79- GrTYrTYAYeee+=−−+−−+)',',',,,(- Primes denote future values, and e’s expected values - Yor Y’eincrease ⇒↑A- Tor T’eincrease ⇒↓A- ror r’eincrease ⇒↓Ad. New IScurve Graph V – 1: The New IScurve