17 c h a p t e r prepared by: fernando quijano and yvonn quijano and modified by gabriel martinez...

1717C H A P T E RC H A P T E R

Prepared by:

Fernando Quijano and Yvonn Quijano

And Modified by Gabriel Martinez

Expectations,Expectations,Output, and PolicyOutput, and Policy

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

How Do Expectations Influence Output and How Do Expectations Influence Output and the Effects of Monetary and Fiscal Policy?the Effects of Monetary and Fiscal Policy?

Consumption and investment are influenced by Consumption and investment are influenced by expected future output, and investment is expected future output, and investment is influenced by the expected future interest rate. influenced by the expected future interest rate.

Since future monetary and fiscal policies affect Since future monetary and fiscal policies affect future output and the future interest rate, future output and the future interest rate, expectations about future policy will affect output expectations about future policy will affect output in the present.in the present.

Moreover, the effect of current policy on output will Moreover, the effect of current policy on output will depend on how current policies affect expectations depend on how current policies affect expectations about future policy. about future policy.


How Do Expectations Influence Output and How Do Expectations Influence Output and the Effects of Monetary and Fiscal Policy?the Effects of Monetary and Fiscal Policy?

This chapter ties together the material on This chapter ties together the material on expectations by incorporating expectations expectations by incorporating expectations into the IS-LM model.into the IS-LM model.

It introduces It introduces rationalrational expectationsexpectations and and allows relatively sophisticated discussion of allows relatively sophisticated discussion of the effects of monetary and fiscal policy.the effects of monetary and fiscal policy.


Expectations andExpectations andDecisions: Taking StockDecisions: Taking Stock

Expectations and Expectations and Spending: The Spending: The ChannelsChannels

Expectations affect consumption and investment decisions, both directly and through asset prices.

17-1


Expectations, Consumption,Expectations, Consumption,and Investment Decisionsand Investment Decisions

Think about time in terms of two periods: the Think about time in terms of two periods: the “present” and the “future,” (which lumps all “present” and the “future,” (which lumps all future years together; denoted by an future years together; denoted by an apostrophe). apostrophe).

Introducing expectations requires thinking Introducing expectations requires thinking about the effects of expected future income about the effects of expected future income ((Y'Y'ee), expected future taxes (), expected future taxes (T'T'ee), and the ), and the expected future real interest rate (expected future real interest rate (r'r'ee).).– Note that expected future government spending has Note that expected future government spending has

no effect on the current IS relation, other than no effect on the current IS relation, other than through its effect on future output and the future through its effect on future output and the future interest rate. interest rate.


Expectations, Consumption,Expectations, Consumption,and Investment Decisionsand Investment Decisions

– Earlier, the Earlier, the ISIS relation was: relation was:

A Y T r C Y T I Y r( , , ) ( ) ( , )

Y C Y T I Y r G ( ) ( , )

Define Define aggregate private spendingaggregate private spending, , AA, as:, as:

Rewrite the Rewrite the ISIS relation as: relation as:

Y A Y T r G ( , , )( , ) ,


Expectations and the Expectations and the ISIS Relation Relation

The Current Period IS curve isThe Current Period IS curve is

but it ignores expectationsbut it ignores expectations

Y A Y T r G ( , , )( , ) ,

Incorporating the role of expectations, Incorporating the role of expectations, then:then: Y A Y T r Ge e e ( , , , ' , ' ' ) T r Y

( , , ) , + ,

Primes denote future values, and Primes denote future values, and eess expected values. expected values.


The positive and negative signs indicate The positive and negative signs indicate that:that:


Y or Y e' A

T or T e' A r o r r e' A

Y A Y T r Ge e e ( , , , ' , ' ' ) T r Y( , , ) , + ,

↓



Is the new, more sophisticated IS curve Is the new, more sophisticated IS curve steeper or flatter than the old IS curve?steeper or flatter than the old IS curve?– Suppose Suppose rr rises, but rises, but r’r’ee stays the same.stays the same.– So investment will become more expensive So investment will become more expensive

this period, but equally expensive next this period, but equally expensive next period.period. This is different than in chapter 5, where a change This is different than in chapter 5, where a change

in in rr was interpreted as a “permanent” change. was interpreted as a “permanent” change.

...$))((

$)(

$

ete

tt

et

ttt z

rrz

rzV 2

111

1

1

1



Is the new, more sophisticated IS curve Is the new, more sophisticated IS curve steeper or flatter than the old IS curve?steeper or flatter than the old IS curve?– Investment projects take several years to Investment projects take several years to

complete, requiring several years of complete, requiring several years of borrowing.borrowing. A change in A change in rr that doesn’t change that doesn’t change rr’e’e is a is a

“temporary” change.“temporary” change.

– Then a change in the cost of borrowing that Then a change in the cost of borrowing that affects affects only oneonly one year impacts investment less year impacts investment less than a permanent change.than a permanent change.



The new The new ISIS curve is relatively steep. curve is relatively steep. A large decrease in the A large decrease in the currentcurrent interest interest

rate is likely to have only a small effect on rate is likely to have only a small effect on equilibrium income:equilibrium income:– A decrease in the current real interest rate A decrease in the current real interest rate

does not have much effect on spending if does not have much effect on spending if future expected rates are not likely to be future expected rates are not likely to be lower as well.lower as well. Suppose r = 3% for t+1, … Suppose r = 3% for t+1, … .. What is the effect of r = 2% What is the effect of r = 2% todaytoday and then rising and then rising

back to 3%, forever?back to 3%, forever?



– The multiplier is likely to be small. If changes in The multiplier is likely to be small. If changes in income are not expected to last, they will have income are not expected to last, they will have a limited effect on consumption and investment.a limited effect on consumption and investment. Suppose General Motors’ Suppose General Motors’ II rises because rises because rr fall; but fall; but

they are both expected to go back to normal they are both expected to go back to normal tomorrow.tomorrow.

Will GM’s suppliers increase their capacity?Will GM’s suppliers increase their capacity? Will GM’s workers increase their consumption Will GM’s workers increase their consumption

significantly?significantly?

– Conclusion: A large decrease in the current Conclusion: A large decrease in the current interest rate is likely to have only a small effect interest rate is likely to have only a small effect on equilibrium income.on equilibrium income.



The New IS CurveThe New IS Curve

tt

t

Y

K

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. Assume, for now,

= e = 0, so r = i


The The LMLM Relation Revisited Relation Revisited

The The LMLM relation is relation is notnot modified because modified because the opportunity cost of holding money the opportunity cost of holding money today depends on the current nominal today depends on the current nominal interest rate (not on the expected interest rate (not on the expected nominal interest rate one year from now).nominal interest rate one year from now).

M

PY L i ( )

The interest rate that enters the LM relation is The interest rate that enters the LM relation is the current nominal interest rate.the current nominal interest rate.


Monetary Policy,Monetary Policy,Expectations, and OutputExpectations, and Output

The New IS-LMThe 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 upward sloping. The equilibrium is at the intersection of the IS and LM curves.

IS A Y T r Y T r Ge e e: ( , , , ' , ' , ' ) Y L MM

PY L r: ( )



An increase in the money supply decreases An increase in the money supply decreases the current nominal interest rate in the SR. the current nominal interest rate in the SR. The amount by which the interest rate The amount by which the interest rate decreases depends on:decreases depends on:– How financial markets revise their expectations How financial markets revise their expectations

of the future nominal interest rate, i’of the future nominal interest rate, i’ee..– How financial markets revise their expectations How financial markets revise their expectations

of both current inflation, of both current inflation, ee, and future inflation, , and future inflation, ’’ee..

17-2

πer i= - πe e er' i' '= -

Assume, for now,= e = 0, so r = i



The Effects of an The Effects of an Expansionary Expansionary Monetary PolicyMonetary Policy

The effects of monetary policy on output depend on how monetary policy affects expectations.

If current r falls and people this to be temporary, IS will won’t shift and Y will change little.

If current r falls and people expect interest rates to remain low forever, IS will shift (because r’e falls) and Y will change much.



Suppose money supply grows faster (Suppose money supply grows faster (ggmm

rises) and rises) and rr falls: falls: We’re still assuming We’re still assuming e = 0.

– If If r’r’ee falls, IS shifts and Y rises much. falls, IS shifts and Y rises much.– If If r’r’ee does not fall, IS doesn’t shift and Y doesn’t does not fall, IS doesn’t shift and Y doesn’t

rise much.rise much. r’r’ee won’t fall if people know the reasoning of Chapter won’t fall if people know the reasoning of Chapter

14: when 14: when ggmm rises, rises, rr falls in the short run but goes falls in the short run but goes

back to back to rr = = rrnn in the medium run. in the medium run.



Everything depends on expectations, so Everything depends on expectations, so anything can happen. Economics is not a anything can happen. Economics is not a science and predictions are useless.science and predictions are useless.

False: expectations aren’t random. People False: expectations aren’t random. People form expectations of future events based on form expectations of future events based on some process of reasoning.some process of reasoning.– We can survey the financial markets and find We can survey the financial markets and find

out what kind of model (or reasoning) they out what kind of model (or reasoning) they follow.follow.



Economists refer to expectations formed in Economists refer to expectations formed in a forward-looking manner as a forward-looking manner as rational rational expectations:expectations:– People form expectations about the future by People form expectations about the future by

assessing the likely course of future expected assessing the likely course of future expected policy and then working out the implications of policy and then working out the implications of future activity.future activity.



Rational expectations:Rational expectations:– People do the best they can to work out the People do the best they can to work out the

implications of an economic policy, given their implications of an economic policy, given their knowledge of the workings of the economy and knowledge of the workings of the economy and the available information.the available information. Typically, we assume that people aren’t stupider than Typically, we assume that people aren’t stupider than

the economist writing the model, so they “know” the the economist writing the model, so they “know” the economist’s model.economist’s model.

– The alternative is to assume that people The alternative is to assume that people routinely make the same mistakes.routinely make the same mistakes. Of course, they often do.Of course, they often do.



Until the 1970s, economists thought of Until the 1970s, economists thought of expectations as:expectations as:– Animal spiritsAnimal spirits—the Keynesian treatment of —the Keynesian treatment of

expectations: important but unexplained.expectations: important but unexplained.– Backward-looking rules—either static or Backward-looking rules—either static or

adaptive expectationsadaptive expectations (expectations adjust to (expectations adjust to past events).past events).

The assumption of rational expectations is The assumption of rational expectations is one of the most important developments in one of the most important developments in macroeconomics in the last 25 years.macroeconomics in the last 25 years.



Keynes suggested three “rules of thumb” for Keynes suggested three “rules of thumb” for expectations formation:expectations formation:– Assume that the past is a good guide for the Assume that the past is a good guide for the

future, unless something suggests the opposite.future, unless something suggests the opposite.– Assume that current prices and output are Assume that current prices and output are

based on a correct forecast.based on a correct forecast.– Assume that the general consensus is correct.Assume that the general consensus is correct.

This means expectations are “based on so flimsy a This means expectations are “based on so flimsy a foundation [they are] subject to sudden and violent foundation [they are] subject to sudden and violent changes.” (Keynes 1937)changes.” (Keynes 1937)



Keynesian ideas about the formation of Keynesian ideas about the formation of expectations (whether animal spirits or expectations (whether animal spirits or adaptive expectations) went out of fashion in adaptive expectations) went out of fashion in academic circles in the late 1970s.academic circles in the late 1970s.

But they are very relevant, so they never But they are very relevant, so they never lost importance in the financial markets.lost importance in the financial markets.

Today academicians are bringing both Today academicians are bringing both insights together, trying to figure out how insights together, trying to figure out how reasonable people make consistent reasonable people make consistent mistakes.mistakes.


Deficit Reduction,Deficit Reduction,Expectations, and OutputExpectations, and Output

In the short run, deficit reduction leads to a In the short run, deficit reduction leads to a decrease in output.decrease in output.

In the medium run, deficit reduction has no In the medium run, deficit reduction has no effect on output, but leads to a lower interest effect on output, but leads to a lower interest rate and higher investment.rate and higher investment.– In the long run, higher investment leads to a In the long run, higher investment leads to a

higher capital stock, and thus a higher level of higher capital stock, and thus a higher level of output. output.

17-3


Deficit Reduction,Deficit Reduction,Expectations, and OutputExpectations, and Output

In the medium run, In the medium run, Y=YY=Ynn..

Even if the deficit is reduced, spending is Even if the deficit is reduced, spending is the same.the same.

But if But if GG falls and falls and TT rises, rises, II must rise for must rise for spending to be the same.spending to be the same.

II rises in the medium run because rises in the medium run because rr falls. falls. In the long run, if In the long run, if II rises, the level of output rises, the level of output

rises.rises.


Back to the Current PeriodBack to the Current Period

Deficit reduction may actually increase Deficit reduction may actually increase spending and output, even in the short run, spending and output, even in the short run, if people take into account the if people take into account the futurefuture beneficial effects of deficit reduction.beneficial effects of deficit reduction.

In response to the announcement of deficit In response to the announcement of deficit reduction,reduction,– Current spending goes down—the IS curve Current spending goes down—the IS curve

shifts to the left.shifts to the left.– Expected future output goes up and Expected future output goes up and r’r’ee goes goes

down—the IS curve shifts to the right.down—the IS curve shifts to the right.



The Effects of a The Effects of a Deficit Reduction on Deficit Reduction on Current OutputCurrent Output

When account is taken of its effect on expectations, the decrease in government spending need not lead to a decrease in output.



Suppose the administration wants to cut the Suppose the administration wants to cut the deficit.deficit.– Cutting expenditure means fewer projects that Cutting expenditure means fewer projects that

benefit legislator’s constituencies; higher taxes benefit legislator’s constituencies; higher taxes are often unpopular.are often unpopular.

The administration can “defer the pain” of The administration can “defer the pain” of the deficit reduction by cutting a little today the deficit reduction by cutting a little today and leaving bigger cuts for tomorrow.and leaving bigger cuts for tomorrow.



Small cuts in government spending and Small cuts in government spending and large expected cuts in the future will cause large expected cuts in the future will cause output to increase more in the current period output to increase more in the current period than without the promise!than without the promise!

This is a concept known as This is a concept known as backloadingbackloading..– Backloading, however, may lead to a problem Backloading, however, may lead to a problem

with the with the credibilitycredibility of the deficit reduction of the deficit reduction program—leaving most of the reduction for the program—leaving most of the reduction for the future, not the present.future, not the present.



To summarize, the change in output as a To summarize, the change in output as a result of deficit reduction depends on:result of deficit reduction depends on:– People’s knowledge of our models of economic People’s knowledge of our models of economic

growth.growth.– People’s patience (do they care about People’s patience (do they care about Y’Y’ee?).?).– The credibility of the programThe credibility of the program– The timing of the programThe timing of the program– The composition of the programThe composition of the program– The state of government finances in the first The state of government finances in the first

place.place.


A Supply-Side WordA Supply-Side Word

This conclusion (basically Clinton-Rubin’s) This conclusion (basically Clinton-Rubin’s) says that raising taxes raises growth, both in says that raising taxes raises growth, both in the long run the long run and in the short run!and in the short run!

But But II should also depend on Taxes. should also depend on Taxes.– Income taxes reduce entrepreneur’s incentives;Income taxes reduce entrepreneur’s incentives;– Business taxes, including tariffs, fees, etc., make Business taxes, including tariffs, fees, etc., make

projects less profitable;projects less profitable;– Some regulations make investment less Some regulations make investment less

attractive.attractive. So cutting So cutting TT andand cutting cutting GG by by moremore may be a may be a

better option.better option.

17 c h a p t e r prepared by: fernando quijano and yvonn quijano and modified by gabriel martinez...

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