Expectations,

Output, and Policy

CHAPTER 17
CHAPTER17
Prepared by:
Fernando Quijano and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier

 Expectations and
17-1
Decisions: Taking Stock
Chapter 17: Expectations, Output,

Figure 17 - 1
Expectations and
Spending: The
Channels
Expectations affect
consumption and
investment
decisions, both
directly and through
and Policy

asset prices.

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 Expectations, Consumption,
and Investment Decisions
Chapter 17: Expectations, Output,

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
and Policy

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.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 3 of 26
 Expectations, Consumption,
and Investment Decisions
Chapter 17: Expectations, Output,

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
and Policy

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.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 4 of 26
 Expectations, Consumption,
and Investment Decisions
Chapter 17: Expectations, Output,

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:
Y  C (Y  T )  I (Y ,r )  G
 Define aggregate private spending or simply,
private spending, A, as:
and Policy

A (Y ,T ,r )  C (Y  T )  I (Y ,r )
Rewrite the IS relation as:
Y  A ( Y ,T ,r )  G
( , ,  )
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 5 of 26
 Expectations and the IS Relation
Chapter 17: Expectations, Output,

 Given Y  C ( Y  T )  I ( Y , r )  G and Y  A ( Y , T , r )  G
( , ,  )
and incorporating the role of expectations,
then:
Y  A (Y , T , r , Y 'e , T 'e r 'e )  G
(  ,  , + ,  ,  )
* Primes denote future values, and es expected values.
and Policy

The positive and negative signs explain how:

Y or Y ' e
  A 
T o r T 'e   A 
r o r r 'e   A 
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 6 of 26
 Expectations and the IS Relation
Chapter 17: Expectations, Output,

Figure 17 - 2
The New IS Curve

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
and Policy

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.

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 Expectations and the IS Relation
Chapter 17: Expectations, Output,

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.
and Policy

 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.

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 Expectations and the IS Relation
Chapter 17: Expectations, Output,

Changes in Y  A ( Y , T , r , Y ' e , T ' e r ' e )  G

(  ,  , + ,  ,  )
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
and Policy

shift the IS curve.

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 The LM Relation Revisited
Chapter 17: Expectations, Output,

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.
M
 Y L (i)
P
and Policy

The interest rate that enters the LM relation is the

current nominal interest rate.

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 Monetary Policy,
17-2
Expectations, and Output
Chapter 17: Expectations, 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:
1. The distinction between the nominal interest
rate and the real interest rate.
2. The distinction between current and expected
and Policy

future interest rates.

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 Monetary Policy,
Expectations, and Output
Chapter 17: Expectations, Output,

Let’s look at this distinction more closely:

 The interest rate is approximately equal to the
nominal interest rate minus expected current
inflation:
r  i   e

 The expected future real interest rate is

approximately equal to the expected future
and Policy

nominal interest rate minus expected future

inflation:

r '  i'   '

e e e

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 Monetary Policy,
Expectations, and Output
Chapter 17: Expectations, Output,

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
and Policy

financial markets to revise their expectations of

both current and future inflation πe and π’e.

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 Monetary Policy,
Expectations, and Output
Chapter 17: Expectations, Output,

Figure 17 - 3
The New IS-LM
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
and Policy

upward sloping. The

equilibrium is at the
intersection of the IS
and LM curves.
M
IS : Y  A (Y ,T ,r ,Y ' ,T ' ,r ' )  G
e e e
LM :  Y L (r )
P
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e 14 of 26
 Monetary Policy Revisited
Chapter 17: Expectations, Output,

Figure 17 - 4
The Effects of an
Expansionary
Monetary Policy

The effects of
monetary policy on
output depend very
much on whether and
how monetary policy
affects expectations.
and Policy

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 Monetary Policy,
Expectations, and Output
Chapter 17: Expectations, Output,

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.
and Policy

 But if expectations remain unchanged, the

effects of the monetary expansion on output
will be small.

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 Monetary Policy,
Expectations, and Output
Chapter 17: Expectations, Output,

Economists refer to expectations formed in a

forward-looking manner as rational
expectations:
People form expectations about the future by
assessing the likely course of future expected
policy and then working out the implications of
future activity.
and Policy

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Chapter 17: Expectations, Output, 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.
and Policy

The assumption of rational expectations is one of

the most important developments in
macroeconomics in the last 25 years.

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 Deficit Reduction,
17-3
Expectations, and Output
Chapter 17: Expectations, Output,

In the short run, deficit reduction leads to a

decrease in output.
 In the medium run, deficit reduction has no
effect on output, but leads to a lower interest
rate and higher investment.
 In the long run, higher investment leads to a
higher capital stock, and thus a higher level of
and Policy

output.

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 The Role of Expectations
About the Future
Chapter 17: Expectations, Output,

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
and Policy

higher capital stock, and to a higher level of

output.

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 Back to the Current Period
Chapter 17: Expectations, Output,

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.
and Policy

 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.

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 Back to the Current Period
Chapter 17: Expectations, Output,

Figure 17 - 5
The Effects of a Deficit
Reduction on Current
Output
When account is taken
of its effect on
expectations, the
decrease in
government spending
and Policy

need not lead to a

decrease in output.

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 Back to the Current Period
Chapter 17: Expectations, Output,

 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.
and Policy

 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.

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 Can a Budget Deficit Reduction Lead
to an Output Expansion? Ireland in the
1980s
Chapter 17: Expectations, Output,

Ireland went through two major deficit reduction

programs in the 1980s.
Table 1 Fiscal and Other Macroeconomic Indicators, Ireland, 1981-1984 and 1986-
1989.
1981 1982 1983 1984 1986 1987 1988 1989
1 Budget deficit (% of -13.0 -13.4 -11.4 -9.5 -10.7 -8.6 -4.5 -1.8
GDP)
2 Output growth rate (%) 3.3 2.3 -0.2 4.4 -0.4 4.7 5.2 5.8
and Policy

3 Unemployment rate 9.5 11.0 13.5 15.0 17.1 16.9 16.3 15.1
(%)
4 Household saving rate 17.9 19.6 18.1 18.4 15.7 12.9 11.0 12.6
(% of disposable income)

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 Back to the Current Period
Chapter 17: Expectations, Output,

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.
and Policy

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 Key Terms
Chapter 17: Expectations, Output,

 aggregate private  adaptive expectations

spending, or private  backloading
spending  credibility
 rational expectations
 animal spirits
and Policy

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