Expectations and the IS-LM • Consumption is not only a function of current income; but of expected future income • Investment is not only a function of current interest rates; but of expected profits Then Y = C(Y-T) + I(Y;r) + G becomesY = C(Y-T; Ye-Te) + I(Y;r;Ye;re) + G
Expectations and the IS-LM • Investment-Savings equilibrium is still: • Positively related to output growth • And Positively related to expected output • Negatively related to current taxes • And Negatively related to expected taxes • Negatively related to interest rates • And Negatively related to expected interest rates
Expectations and the IS-LM • How is the IS curve affected by expectations? It is much steeper • Steeper IS means Output less sensitive to current real interest rates. Why? • If current rates fall but future rates are expected to be unchanged it will not lead to a big change in spending • Smaller multiplier: changes in income are not expected to last; they affect consumption less
Expectations and the IS-LM • How about the LM curve? • The Liquidity of Money is not affected by expectations because it is affected by current demand for money • Affected by current expenditure needs • If expectations are different then the adjustments will be done in the future
Expectations and Monetary Policy • Distinction between interest rates: • Nominal interest rates and real interest rates • Current and expected future interest rates r = i - e re = ie - e’ • Central Bank decreasing i has two effects: • Affects future expected nominal interest rates • Affects current and future expected inflation
Expectations and Monetary Policy • Consider expansionary monetary policy (to fight off a recession) • Steeper IS implies that monetary policy is less effective (smaller impact on output) • If policy affects expectations and markets interpret it as lower future rates; then IS also shifts out: bigger impact on output • If policy is a “surprise” then expectations change; otherwise they won’t.
Expectations and Monetary Policy • Rational Expectations: expectations formed in a forward-looking manner • Early 70’s: Lucas Critique • Before economics dealt with expectations as • “animal spirits” (Keynes): important but unpredictable movements • Adaptive expectations: backward-looking • What happens today influences our expectations for the future • Our future expectations influence the present