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Expectations, Output, and Policy

Expectations, Output, and Policy. A look at fiscal and monetary policy when consumption, investment, and stock and bond prices are influenced by expectations. Spending and Expectations: The Channels. Depends on: Depends on Expectations of:

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Expectations, Output, and Policy

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

  2. 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 Expectations, Output, and Policy Expectations & Decisions: Taking Stock Expectations and the IS Relation

  3. Expectations, Output, and Policy Expectations & Decisions: Taking Stock Expectations and the IS Relation 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 +, -, -

  4. Expectations, Output, and Policy Expectations & Decisions Expectations and the IS Relation IS with Expectations: Y = A(Y,T,r,Y'e,T'e,r'e) + G +,-,-, +, -, - • Primes (’) denote: Future period • e denotes: Expected values

  5. a rA Current interest rate, r b rB G > 0, or Y´e > 0 T > 0, or T ´e > 0, or r´e > 0 IS YB YA Current output, Y Expectations, Output, and Policy Expectations & Decisions: Taking Stock Question: Why is this IS steeper?

  6. Expectations, Output, and Policy Expectations & 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.

  7. Expectations, Output, and Policy The LM Revisited Question: Do expectations influence the demand for money?

  8. The LM Relation: Current nominal interest rate The IS Relation: Current and expected future real interest rate Expectations, Output, and Policy Monetary Policy, Expectations, and Output The IS and LM Model • Interest Rates • Nominal and real • Current and expected

  9. Expectations, Output, and Policy Monetary Policy, Expectations, and Output Recall: r = i -  r'e = i'e - e

  10. Expectations, Output, and Policy Monetary Policy, Expectations, and Output The impact of an increase in the money supply depends on: • If financial markets revise their expectations of i'e • If financial markets revise their expectations of  e as 'e

  11. LM: Expectations, Output, and Policy Monetary Policy, Expectations, and Output Assume:  e and 'e = 0 r = current real interest rates r'e = expected future real interest rates Then: IS: Y = A(Y,T,r,Y'e,T'e,r'e) + G

  12. LM LM´´ • With no change in expectations • LM to LM´´ & YA to YB Interest Rate, i • With a change in expectations • IS´ to IS´´ & B to C • rB to rC & YB to YC A rA C rC B rB IS´´ IS YA YC YB Output, Y Expectations, Output, and Policy The Effects of an Expansionary Monetary Policy • Assume a recession & the Fed • increases the money supply

  13. Expectations, Output, and Policy Monetary Policy, Expectations, and Output • 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:

  14. Expectations, Output, and Policy Deficit Reduction, Expectations, and Output Question for Discussion: How could deficit reduction cause an increase in spending in the short-run?

  15. Expectations, Output, and Policy Deficit Reduction, Expectations, and 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. The Effects of Deficit Reduction on Current Output

  16. LM ? Current interest rate, r ? r´e < 0 Y´e > 0 G < 0 IS Current output, Y Expectations, Output, and Policy Deficit Reduction, Expectations, and Output The Effects of Deficit Reduction on Current Output

  17. Expectations, Output, and Policy The Effects of Deficit Reduction on Current Output • 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:

  18. Expectations, Output, and Policy The Effects of Deficit Reduction on Current Output • 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:

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