IS-LM with expectations Econ 302 Slide #1 Expectations, Output, and Policy A look at fiscal and monetary policy when consumption, investment, and stock and bond prices are influenced by expectations.

IS-LM with expectations Econ 302 Slide #2 Expectations & Decisions: Taking Stock Expectations and the IS Relation Expectations, 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 Econ 302 Slide #3 Expectations & Decisions: Taking Stock Expectations and the IS Relation Expectations, 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 Econ 302 Slide #4 Expectations & Decisions Expectations and the IS Relation Expectations, 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 Econ 302 Slide #5 IS Current output, Y Current interest rate, r rArA YAYA a Expectations & Decisions: Taking Stock Question: Why is this IS steeper? Expectations, Output, and Policy  G > 0, or  Y´ e > 0  T > 0, or  T ´ e > 0, or  r´ e > 0 YBYB rBrB b

IS-LM with expectations Econ 302 Slide #6 Expectations & the New IS Curve Why is this IS steeper? Expectations, 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 Econ 302 Slide #7 The LM Revisited Expectations, Output, and Policy Question: Do expectations influence the demand for money?

IS-LM with expectations Econ 302 Slide #8 Monetary Policy, Expectations, and Output Expectations, Output, and Policy The IS and LM Model Interest Rates Nominal and real Current and expected The LM Relation: Current nominal interest rate The IS Relation: Current and expected future real interest rate

IS-LM with expectations Econ 302 Slide #9 Monetary Policy, Expectations, and Output Expectations, Output, and Policy Recall: r = i -  r' e = i' e -  e

IS-LM with expectations Econ 302 Slide #10 Monetary Policy, Expectations, and Output Expectations, Output, and Policy If financial markets revise their expectations of i' e If financial markets revise their expectations of  e as  ' e The impact of an increase in the money supply depends on:

IS-LM with expectations Econ 302 Slide #11 Monetary Policy, Expectations, and Output Expectations, Output, and Policy  e and  ' e = 0 Assume: 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 LM:

IS-LM with expectations Econ 302 Slide #12 LM´´ With no change in expectations LM to LM´´ & Y A to Y B Output, Y Interest Rate, i IS LM YAYA A rArA The Effects of an Expansionary Monetary Policy Expectations, Output, and Policy Assume a recession & the Fed increases the money supply IS´´ With a change in expectations IS´ to IS´´ & B to C r B to r C & Y B to Y C C YCYC rCrC rBrB B YBYB

IS-LM with expectations Econ 302 Slide #13 Monetary Policy, Expectations, and Output Expectations, 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:

IS-LM with expectations Econ 302 Slide #14 Deficit Reduction, Expectations, and Output Expectations, Output, and Policy Question for Discussion: How could deficit reduction cause an increase in spending in the short-run?

IS-LM with expectations Econ 302 Slide #15 Deficit Reduction, Expectations, and Output The Effects of Deficit Reduction on Current Output Expectations, Output, and Policy Current spending (G) falls. At a given interest rate, Y falls. Expected future output (Y te ) 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 Econ 302 Slide #16 Deficit Reduction, Expectations, and Output The Effects of Deficit Reduction on Current Output Expectations, Output, and Policy LM IS Current output, Y Current interest rate, r  G < 0 ?  r´ e < 0  Y´ e > 0 ?

IS-LM with expectations Econ 302 Slide #17 The Effects of Deficit Reduction on Current Output Expectations, 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:

IS-LM with expectations Econ 302 Slide #18 The Effects of Deficit Reduction on Current Output Expectations, 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: