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.
IS-LM with expectations Slide #2Econ 302
Expectations & Decisions: Taking StockExpectations & Decisions: Taking Stock
Expectations and the IS Relation
Expectations, Output, and PolicyExpectations, Output, and Policy
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
IS-LM with expectations Slide #3Econ 302
Expectations & Decisions: Taking StockExpectations & Decisions: Taking Stock
Expectations and the IS Relation
Expectations, Output, and PolicyExpectations, Output, and Policy
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 +, -, -
IS-LM with expectations Slide #4Econ 302
Expectations & DecisionsExpectations & Decisions
Expectations and the IS Relation
Expectations, Output, and PolicyExpectations, Output, and Policy
IS with Expectations: Y = A(Y,T,r,Y'e,T'e,r'e) + G +,-,-, +, -, -
• Primes (’) denote: Future period
• e denotes: Expected values
IS-LM with expectations Slide #5Econ 302
IS
Current output, Y
Cu
rren
t in
tere
st r
ate,
r
rA
YA
a
Expectations & Decisions: Taking StockExpectations & Decisions: Taking Stock
Question: Why is this IS steeper?
Expectations, Output, and PolicyExpectations, Output, and Policy
G > 0, or
Y´e > 0
T > 0, or
T ´e > 0, or
r´e > 0
YB
rBb
IS-LM with expectations Slide #6Econ 302
Expectations & the New IS CurveExpectations & the New IS Curve
Why is this IS steeper?
Expectations, Output, and PolicyExpectations, Output, and Policy
•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.
IS-LM with expectations Slide #7Econ 302
The LM RevisitedThe LM Revisited
Expectations, Output, and PolicyExpectations, Output, and Policy
)(iYLP
M
MoneyofSupplyPM
MoneyforDemandiYL )(
Question:Question:
Do expectations influence the demand for money?Do expectations influence the demand for money?
IS-LM with expectations Slide #8Econ 302
Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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
IS-LM with expectations Slide #9Econ 302
Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
Recall:Recall:
r = i -
r'e = i'e - e
IS-LM with expectations Slide #10Econ 302
Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
• 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:
IS-LM with expectations Slide #11Econ 302
Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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
IS-LM with expectations Slide #12Econ 302
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
Expectations, Output, and PolicyExpectations, Output, and 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
IS-LM with expectations Slide #13Econ 302
Monetary Policy, Expectations, and OutputMonetary Policy, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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:
IS-LM with expectations Slide #14Econ 302
Deficit Reduction, Expectations, and OutputDeficit Reduction, Expectations, and Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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?
IS-LM with expectations Slide #15Econ 302
Deficit Reduction, Expectations, and OutputDeficit Reduction, Expectations, and Output
The Effects of Deficit Reduction on Current OutputThe Effects of Deficit Reduction on Current Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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.
IS-LM with expectations Slide #16Econ 302
Deficit Reduction, Expectations, and OutputDeficit Reduction, Expectations, and Output
The Effects of Deficit Reduction on Current OutputThe Effects of Deficit Reduction on Current Output
Expectations, Output, and PolicyExpectations, Output, and Policy
LM
IS
Current output, Y
Cu
rren
t in
tere
st r
ate,
r
G < 0
?
r´e < 0
Y´e > 0
?
IS-LM with expectations Slide #17Econ 302
The Effects of Deficit Reduction on Current OutputThe Effects of Deficit Reduction on Current Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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:
IS-LM with expectations Slide #18Econ 302
The Effects of Deficit Reduction on Current OutputThe Effects of Deficit Reduction on Current Output
Expectations, Output, and PolicyExpectations, Output, and Policy
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:
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