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Understanding Expectations in the IS-LM Framework

This text explores how expectations influence the IS-LM model in economics. It highlights that consumption is not just a function of current income, but also of expected future income. Similarly, investment decisions hinge on anticipated profits rather than current interest rates. The IS curve's steepness illustrates output's reduced sensitivity to current rates due to expected future rates. Additionally, the role of monetary policy in shaping these expectations and its implications on interest rates and inflation is examined, emphasizing the distinction between rational and adaptive expectations.

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Understanding Expectations in the IS-LM Framework

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  1. 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

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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.

  7. 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

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