IS-LM with expectations Econ 302 Slide #1 Expectations, Output, and Policy A look at fiscal and...

IS-LM with expectations Slide #1Econ 302

Expectations, Output, and PolicyExpectations, Output, and Policy

A look at fiscal and monetary policywhen consumption, investment, andstock and bond prices are influencedby expectations.

A look at fiscal and monetary policywhen consumption, investment, andstock and bond prices are influencedby expectations.


Expectations & Decisions: Taking StockExpectations & Decisions: Taking Stock

Expectations and the IS Relation


Spending and Expectations: The Channels

Depends on: Depends on Expectations of:

Consumption > Current after-tax labor income > Future after-tax labor income> Human wealth > Future real interest rates

> Nonhuman wealth > Stocks > Future real dividends

> Future real interest rates > Bonds > Future nominal interest rates

Investment > Current cash flow > Future after-tax profits> Present value of after-tax profits > Future real interest rates





An Assumption: Two time periods; (1) the current (current year) (2) the future (all future years lumped together) The IS Model:

IS Before Expectations: Y = C(Y-T) + I(Y,r) + G

Aggregate Private Spending (A): A(Y,T,r) C(Y-T) + I(Y,r)

IS: Y = A(Y,T,r)+G +, -, -


Expectations & DecisionsExpectations & Decisions



IS with Expectations: Y = A(Y,T,r,Y'e,T'e,r'e) + G +,-,-, +, -, -

• Primes (’) denote: Future period

• e denotes: Expected values


IS

Current output, Y

Cu

rren

t in

tere

st r

ate,

r

rA

YA

a


Question: Why is this IS steeper?


G > 0, or

Yé > 0

T > 0, or

T é > 0, or

ré > 0

YB

rBb


Expectations & the New IS CurveExpectations & the New IS Curve

Why is this IS steeper?


•A change in the current real interest rate given unchanged expectations does not have as much impact on spending.

•The multiplier is likely to be small because a change in

current income given unchanged expectations of future will have a small impact on spending.


The LM RevisitedThe LM Revisited


)(iYLP

M

MoneyofSupplyPM

MoneyforDemandiYL )(

Question:Question:

Do expectations influence the demand for money?Do expectations influence the demand for money?


Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output


The IS and LM ModelThe IS and LM Model

Interest Rates

• Nominal and real

• Current and expected

The LM Relation:The LM Relation: Current nominal interest rate

The IS Relation:The IS Relation: Current and expected future real interest rate




Recall:Recall:

r = i -

r'e = i'e - e




• If financial markets revise their expectations of i'e

• If financial markets revise theirexpectations of e as 'e

The impact of an increase in the money supply depends on:




e and 'e = 0Assume:Assume:

r = current real interest rates

r'e = expected future real interest rates

Then:Then: IS: Y = A(Y,T,r,Y'e,T'e,r'e) + G

LM: )(rYLPM


LM´´

• With no change in expectations LM to LM´´ & YA to YB

Output, Y

Inte

res

t R

ate,

i

IS

LM

YA

ArA

The Effects of an Expansionary Monetary PolicyThe Effects of an Expansionary Monetary Policy


• Assume a recession & the Fed increases the money supply

IS´´

• With a change in expectations IS´ to IS´´ & B to C rB to rC & YB to YC

C

YC

rC

rB

B

YB




The effects of monetary policy depend crucially on their effect on expectations If expectations change, the impact of monetary policy will be

large If expectations do not change, the impact will be small

Expectations are not arbitrary Rational expectations: Expectations formed in a forward-

looking manner

A Summary:A Summary:


Deficit Reduction, Expectations, and OutputDeficit Reduction, Expectations, and Output


Question for Discussion:Question for Discussion:

How could deficit reduction cause an increase in spending in the short-run?How could deficit reduction cause an increase in spending in the short-run?



The Effects of Deficit Reduction on Current OutputThe Effects of Deficit Reduction on Current Output


Current spending (G) falls. At a given interest rate, Y falls.

Expected future output (Yte) increases. At a given interest rate, Y increases.

Expected future interest rates fall. At a given current interest rate, Y increases.





LM

IS

Current output, Y

Cu

rren

t in

tere

st r

ate,

r

G < 0

?

r´e < 0

Y´e > 0

?




The relationship between IS and LM determine the effect of a deficit reduction program.

The smaller the decrease in current G, the smaller the adverse effect on spending today. Backloading may be more likely to increase Y.

Backloading could reduce credibility. Government must balance future cuts in spending with the need to be credible today.

Generally, if deficit reduction improves expectations, the short-run effect will be less painful.

Observations:Observations:




A deficit reduction program may increase output in the short-run if... The program is credible Current spending relative to future cuts are

weighted properly The program removes some distortions in the

economy

A Summary:A Summary:

IS-LM with expectations Econ 302 Slide #1 Expectations, Output, and Policy A look at fiscal and...

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