Download Chapter 17. Expectations, Output

CHAPTER 17. EXPECTATIONS, OUTPUT,
AND POLICY
I.
MOTIVATING QUESTION
How Do Expectations Influence the Determination of Output and the Effects of
Monetary and Fiscal Policy?
Consumption and investment are influenced by expected future output, and investment is influenced by
the expected future interest rate. Since future monetary and fiscal policies affect future output and the
future interest rate, expectations about future policy will affect output in the present. Moreover, the
effect of current policy on output will depend on how current policy measures affect expectations about
future policy.
II.
WHY THE ANSWER MATTERS
This chapter ties together the material on expectations by incorporating expectations into the IS-LM
model. It introduces rational expectations in an intuitive and natural way and allows relatively
sophisticated discussion of the effects of monetary and fiscal policy.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
The chapter introduces rational expectations in the context of the IS-LM model by allowing economic
agents to forecast the effects of future policy and to use these forecasts when determining current
consumption and investment.
IV. SUMMARY OF THE MATERIAL
1.
Expectations and Decisions: Taking Stock
Think about time in terms of two periods: the present and the future, which lumps all future years
together. Then, in the current period, the IS relation derived earlier in the text can be written as
Y=A(Y,T,r)+G,
(17.1)
+- where A—which stands for aggregate private spending—is defined as consumption plus investment.
Introducing expectations requires thinking about the effects of expected future income (Y'e), expected
future taxes (T'e), and the expected future real interest rate (r'e). Note that expected future government
spending has no effect on the current IS relation, other than through its effect on future output and the
future interest rate. From Chapter 16, an increase in expected future income will increase consumption
and investment (since expected profits are likely to increase). An increase in expected future taxes will
reduce expected disposable income, which will reduce consumption. An increase in the expected future
real interest rate will reduce investment. Given these relationships, the IS curve can be rewritten as
Y=A(Y,T,r,Y'e,T'e,r'e)+G.
+- - + - -
(17.2)
Given the values of expected future variables, the new IS curve remains downward-sloping in Y-r space,
but it is likely to be steeper than the IS curve developed earlier in the book, for two reasons. First, given
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expected future interest rates, changes in the current interest rate have a relatively small effect on present
values (of expected labor income and expected profits) and, thus, a relatively small effect on current
spending (on consumption and investment), given income. Second, the multiplier is likely to be small,
since, given expectations of future income, current income has a relatively small effect on consumption
and investment.
The LM curve is unaffected by the introduction of expectations, since money demand depends on the
current level of transactions. Money holdings can be adjusted in the future if the level of transactions
changes.
2.
Monetary Policy, Expectations, and Output
For simplicity, assume that expected inflation is zero, so that the nominal interest rate equals the real
interest rate. Then, the LM curve can be written as
M/P=YL(r).
(17.3)
Now consider an increase in the current period money supply. Such an increase shifts the LM curve to
the right, increasing output and reducing the interest rate. In the absence of changes in expectations, the
increase in output will be relatively small since the IS curve is steep. If, however, an increase in the
current money supply leads people to expect an increase in the future money supply, expected future
output will increase, and the expected future interest rate will decrease. Both of these effects cause the
current period IS curve to shift to the right, increasing output further. Thus, the effects of policy depend
on changes in expectations.
The preceding discussion relies on sophisticated formation of expectations by economic actors who are
assumed to assess the likely course of future policy and to work out the economic implications.
Expectations formed in this manner are called rational expectations. A box in the text describes the
historical developments that led to rational expectations becoming the benchmark assumption in
economics.
3.
Deficit Reduction, Expectations, and Output
In the basic IS-LM model introduced in the Core, a reduction in the government budget deficit reduced
current output. Once expectations are introduced, the effect of deficit reduction on current output
becomes ambiguous, because deficit reduction leads to a fall in the real interest rate and an increase in
investment in the medium run and, thus, to an increase in output in the long run. In terms of equation
(17.2), Y'e increases and r'e falls, both of which tend to shift the current period IS curve to the right. The
direct effect of the deficit reduction—as a result of an increase in T or a reduction in G—shifts the
current period IS curve to the left. The net effect on output—whether the current period IS curve shifts
right or left—could be positive or negative.
This analysis suggests that a deficit reduction program is less likely to reduce current output to the extent
that it is backloaded, i.e., takes place further in the future, because the direct negative effects on output
(through reduced government spending or increased taxes) would be postponed. On the other hand, a
backloaded deficit reduction program may not be very credible. People may not believe that the
government will follow through on politically difficult spending reductions and tax increases promised in
the future.
A box in the text discusses Ireland's two attempts at deficit reduction in the 1980s. The first, in the early
part of the decade, was associated with low growth and an increase in the unemployment rate. The
second, in the latter half of the decade, was associated with high growth and a reduction in the
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unemployment rate. Some economists have argued that the second deficit reduction, which focused on
spending cuts and tax reform, provides an example of an expansionary deficit reduction. They argue that
the first deficit reduction, which focused on tax increases and did not change the size of the government’s
role in the economy, did not change expectations about the future very much. The text argues that
evidence on the saving rate is consistent with this story. During the first deficit reduction, the saving rate
rose, which suggests increased pessimism about the future. During the second deficit reduction, the
saving rate fell, which suggests increased optimism about the future. On the other hand, monetary policy
and other economic factors also differed between the two episodes, so the difference in results cannot be
attributed entirely to expectations.
V.
PEDAGOGY
The presentation of the effects of expected monetary policy can be aided by drawing two IS-LM
diagrams, one for the present and one for the future. Begin by working out the short-run effects of
expected future monetary policy in the IS-LM diagram representing the future. In the long run, future
monetary policy will be neutral. The (short-run) changes in future output and the future interest rate
show how expected future output and the expected future interest rate change. Use these effects on
expectations to determine the effects on current variables in the IS-LM diagram representing the present.
This technique ignores changes in expected inflation, but it does give a flavor for the effects of Fed
watching on the economy.
The use of present and future IS-LM diagrams is less useful for illustrating the effects of expected fiscal
policy, because changes in fiscal policy affect capital accumulation and output in the long run.
VI. EXTENSIONS
The first edition of the text used the Clinton deficit reduction package as an illustration of the design of
deficit reduction programs. One point that emerged from this discussion was how expectations about the
response of the central bank to deficit reduction affected the ultimate effect of the policy on output.
Instructors might want to include the potential response of the Federal Reserve in the discussion of
deficit reduction programs.
VII. OBSERVATIONS
Once expectations are taken into account, the effect (on current output and the current interest rate) of a
current change in an exogenous variable depends in part on how this change affects expectations about
the future. Likewise, current output and the current interest rate can be affected by expectations about
future changes in exogenous variables, even when no current exogenous variable changes.
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