1 / 24

17-1 Expectations and Decisions: Taking Stock

17-1 Expectations and Decisions: Taking Stock. Figure 17 - 1. Expectations and Spending: The Channels. Expectations, Consumption, and Investment Decisions. Expectations affect consumption and investment decisions, both directly and through asset prices.

marcos
Download Presentation

17-1 Expectations and Decisions: Taking Stock

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. 17-1 Expectations and Decisions: Taking Stock Figure 17 - 1 Expectations and Spending: The Channels Expectations, Consumption, and Investment Decisions Expectations affect consumption and investment decisions, both directly and through asset prices.

  2. 17-1 Expectations and Decisions: Taking Stock Expectations, Consumption, and Investment Decisions Note from Figure 17-1: • An increase in current and expected future after-tax real labor income, or a decrease in current and expected future real interest rates, increases human wealth and leads to an increase in consumption. • An increase in current and expected future real dividends, or a decrease in current and expected future real interest rates, increases stock prices which leads to an increase in nonhuman wealth and an increase in consumption.

  3. 17-1 Expectations and Decisions: Taking Stock Expectations, Consumption, and Investment Decisions Note from Figure 17-1: • A decrease in current and expected future nominal interest rates leads to an increase in bond prices, which leads to an increase in nonhuman wealth and an increase in consumption. • An increase in current and expected future real after-tax profits, or a decrease in current and expected future real interest rates, increases the present value of real after-tax profits, which leads to an increase in investment.

  4. 17-1 Expectations and Decisions: Taking Stock Expectations and the IS Relation • Consumption and investment depend on expectations of the future. To take into account the effect of expectations, we do the following: Earlier, the IS relation was: Define aggregate private spending or simply, private spending, A, as: Rewrite the IS relation as:

  5. 17-1 Expectations and Decisions: Taking Stock Expectations and the IS Relation • Given and and incorporating the role of expectations, then: * Primes denote future values, and e denotes expected values. The positive and negative signs explain how:

  6. 17-1 Expectations and Decisions: Taking Stock Figure 17 - 2 The New IS Curve Expectations and the IS Relation Given expectations, a decrease in the real interest rate leads to a small increase in output: The IS curve is steeply downward sloping. Increases in government spending or in expected future output shift the IS curve to the right. Increases in taxes, in expected future taxes, or in the expected future real interest rate shift the IS curve to the left.

  7. 17-1 Expectations and Decisions: Taking Stock Expectations and the IS Relation • The new IS curve is steep, which means that a large decrease in the current interest rate is likely to have only a small effect on equilibrium income, for two reasons: • A decrease in the current real interest rate does not have much effect on spending if future expected rates are not likely to be lower as well. • The multiplier is likely to be small. If changes in income are not expected to last, they will have a limited effect on consumption and investment.

  8. 17-1 Expectations and Decisions: Taking Stock Expectations and the IS Relation • Changes in • other than Y and r, shift the IS curve: • Changes in T (current taxes) or G (current government spending) shift the IS curve • Changes in expected future variables also shift the IS curve.

  9. 17-1 Expectations and Decisions: Taking Stock The LM Relation Revisited • The LM relation is not modified because the opportunity cost of holding money today depends on the current nominal interest rate, not on the expected nominal interest rate one year from now. The interest rate that enters the LM relation is the current nominal interest rate.

  10. 17-2 Monetary Policy, Expectations, and Output • When the Fed expanded the money supply, “the” interest rate went down, and spending increased. There are many interest rates, keep these two distinctions in mind: • The distinction between the nominal interest rate and the real interest rate. • The distinction between current and expected future interest rates.

  11. 17-2 Monetary Policy, Expectations, and Output From the Short Nominal Rate to Current and Expected Real Rates • Decreasing the current nominal interest rate i effects the current and expected future real interest rates depending on two factors: • Whether the increase in the money supply leads financial markets to revise their expectations of the future nominal interest rate, i’e. • Whether the increase in the money supply leads financial markets to revise their expectations of both current and future inflation πeand π’e.

  12. 17-2 Monetary Policy, Expectations, and Output Figure 17 - 3 The New IS–LM From the Short Nominal Rate to Current and Expected Real Rates The IS curve is steeply downward sloping. Other things equal, a change in the current interest rate has a small effect on output. The LM curve is upward sloping. The equilibrium is at the intersection of the IS and LM curves.

  13. 17-2 Monetary Policy, Expectations, and Output Figure 17 - 4 The Effects of an Expansionary Monetary Policy Monetary Policy Revisited The effects of monetary policy on output depend very much on whether and how monetary policy affects expectations.

  14. 17-2 Monetary Policy, Expectations, and Output Monetary Policy Revisited • The effects of monetary policy depend crucially on its effect on expectations: • If a monetary expansion leads financial investors, firms, and consumers to revise their expectations of future interest rates and output, then the effects of the monetary expansion on output may be very large. • But if expectations remain unchanged, the effects of the monetary expansion on output will be small. People form expectations about the future by assessing the likely course of future expected policy and then working out the implications of future activity. Economists refer to expectations formed in a forward-looking manner as rationalexpectations

  15. Rational Expectations Until the 1970s, macroeconomists thought of expectations as: • Animal spirits - the Keynesian treatment of expectations, which considers them important but unexplained. • Backward-looking rules—either static or adaptive expectations. The assumption of rational expectations is one of the most important developments in macroeconomics in the last 25 years.

  16. 17-3 Deficit Reduction, Expectations,and Output • Recall the conclusions we reached in the core about the effects of a budget deficit reduction: • In the long run, a reduction in the budget deficit is likely to be beneficial for the economy. In the medium run, a lower budget deficit implies higher saving and higher investment. In the long run, higher investment translates into higher capital and thus higher output. • In the short run, however, a reduction in the budget deficit, unless it is offset by a monetary expansion, leads to lower spending and to a contraction in output.

  17. 17-3 Deficit Reduction, Expectations,and Output The Role of Expectations about the Future • Let’s review what we learned about the effects of a deficit reduction in the medium run and the long run: • In the medium run, a deficit reduction has no effect on output. It leads, however, to a lower interest rate and to higher investment. • In the long run, higher investment leads to a higher capital stock, and to a higher level of output.

  18. 17-3 Deficit Reduction, Expectations,and Output Figure 17 - 5 The Effects of a Deficit Reduction on Current Output Back to the Current Period When account is taken of its effect on expectations, the decrease in government spending need not lead to a decrease in output.

  19. 17-3 Deficit Reduction, Expectations,and Output Back to the Current Period • Deficit reduction may actually increase spending and output, even in the short run, if people take into account the future beneficial effects of deficit reduction. • In response to the announcement of deficit reduction, • Current spending goes down—the IS curve shifts to the left. • Expected future output goes up—the IS curve shifts to the right. • And the interest rate goes down—the IS curve shifts to the right.

  20. 17-3 Deficit Reduction, Expectations,and Output Back to the Current Period • Small cuts in government spending and large expected cuts in the future will cause output to increase more in the current period—a concept known as backloading. • Backloading, however, may lead to a problem with the credibility of the deficit reduction program—leaving most of the reduction for the future, not the present. • The government must play a delicate balancing act: enough cuts in the current period to show a commitment to deficit reduction and enough cuts left to the future to reduce the adverse effects on the economy in the short run.

  21. Can a Budget Deficit Reduction Lead to an Output Expansion? Ireland in the 1980s

  22. 17-3 Deficit Reduction, Expectations,and Output Back to the Current Period • To summarize, the change in output as a result of deficit reduction depends on: • The credibility of the program • The timing of the program • The composition of the program • The state of government finances in the first place.

  23. Key Terms • aggregate private spending, or private spending • animal spirits • adaptive expectations • rational expectations • backloading • credibility

More Related