MonMacro Lecture2

faculty of economics
and business
15-09-2020 | 1
Monetary Macroeconomics
EBB130A05
Academic Year 2022-2023
Lecture 2
The Expectations-Augmented
IS-LM Model
(Chapters 15 & 16)

and business
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Last Week…
› We introduced the concept of discount rates to compute
the (expected) present discounted value of future
revenues to price bonds and stocks.
› We learned about arbitrage and how to infer the yield-to-

maturity and expected future short-term interest rates.
› We learned how to price stocks, and the effects of

monetary policy on stock prices.
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This Week…
› Key focus of today’s lecture is on incorporating the role of
expectations in the standard IS-LM framework.
› For that purpose, we revisit:

 Optimal consumption decisions.
 Optimal investment decisions.
› We investigate how including expectations affect monetary

and fiscal policy.
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Introduction
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Expectations in the IS-LM Model
Does a future
decrease of interest
rates affect today’s
equilibrium in the
standard IS-LM
model?
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Expectations in the IS-LM Model
No!
Equilibirum in IS-LM
model only depends
on today’s variables
But do consumers,
investors and firms
make decisions like
that?
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Expectations in the real world

On January 22nd, 2015, the ECB announced
introduction of Asset Purchase Programme (APP, also
known as QE).
Consequence: expectations of lower future interest

rates.
› “ECB expands purchases to include bonds issued

by euro area central governments, agencies and
European institutions”
› “Combined monthly asset purchases to amount to

€60 billion”
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Expectations in the real world
› Announcement of
asset purchases
(decrease in future
interest rates)
reduces rates
today.
› Future decrease in
interest rates does
affect the current
equilibrium!
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Today’s Plan
Study lifetime consumption planning.
(Chapter 15)
Analyze optimal investment decisions.

(Chapter 15)
Present the expectations-augmented IS-LM model.

(Chapter 16)
Discuss the implications for economic policy.

(Chapter 16)
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1. Optimal consumption decisions

(see chapter 15)
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Optimal Consumption Decisions

If consumers are forward-looking they should be making
their consumption decisions in the same way firms make
theirs on investment:
 Consumers should look at their whole life-cycle and

form an expectation about the value of their lifetime
wealth 𝑾𝑾𝒕𝒕 .
 Then they should use a share of their lifetime wealth

for consumption purpose in each period of life.
This implies that 𝑪𝑪𝒕𝒕 = 𝑪𝑪(𝑾𝑾𝒕𝒕 ) and not 𝑪𝑪𝒕𝒕 = 𝑪𝑪 𝒀𝒀𝒕𝒕 − 𝑻𝑻𝒕𝒕 .
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How would such a calculation look like?
› Consumer would add:

 Financial wealth (value of stocks and bonds).
 Housing wealth (value of the house he/she owns minus the
mortgage still due).
 Human wealth: present value of future after-tax labour
income.
› Consumer would decide how much to spend out of total

wealth, typically a proportion of total wealth such that
consumption remains roughly at the same level over time.
› If the demanded level of consumption is larger than current

income, he/she borrows the difference.
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Is this a realistic description? Why or why not?
1. People might not want constant life-time consumption.
2. Amount of computation and foresight involved in

computation far exceeds what people use in real-life.
3. Computation is based on expectations, which might

turn out better or worse. To be prudent, people might
not want to borrow to have constant consumption.
4. Credit constraints: banks might not be willing to lend

you the money.
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› The last three reasons suggest that consumption does
not only depend on total wealth, but also on current
income.
› To capture this, we write:
𝑪𝑪𝒕𝒕 = 𝑪𝑪 𝑾𝑾𝒕𝒕 , 𝒀𝒀𝒕𝒕 − 𝑻𝑻𝒕𝒕

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Example: borrowing constraints

Consider the effect
on consumption of a
permanent
reduction in taxes
announced ahead of
time.
Note how the effect

on consumption
levels differs
between agent (ii)
who is credit
constrained and
agent (i) who is not.
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Example lifetime income: tax-cuts
› Consumption today depends on lifetime

income (in addition to current income).
› As an illustration, we compare the effect on

lifetime income of a permanent and a
temporary tax cut.
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Assume the following initial conditions:
› Annual income at the start: D = $40.000.
› Income growth: g = 2% per year.
› Constant nominal interest rate: i = 4% per year.
› Initial tax rate t = 25%.
› Assume person lives forever (this simplifies the

math).
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› Then present value (PV) of lifetime income =
𝐷𝐷 1−𝑡𝑡 𝐷𝐷 1+𝑔𝑔 1−𝑡𝑡 𝐷𝐷 1+𝑔𝑔 2 1−𝑡𝑡

+ + +… = $ 1.500.000
1+𝑖𝑖 1+𝑖𝑖 2 1+𝑖𝑖 3
› Assume a permanent tax-cut from t = 25% to t’

= 20%, then PV lifetime income =
𝐷𝐷 1−𝑡𝑡′ 𝐷𝐷 1+𝑔𝑔 (1−𝑡𝑡′) 𝐷𝐷 1+𝑔𝑔 2(1−𝑡𝑡′)

+ + +…= $ 1.600.000
1+𝑖𝑖 1+𝑖𝑖 2 1+𝑖𝑖 3
› Lifetime income changes by 6,7% for permanent

tax-cut
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› Assume a temporary tax-cut from t = 25% to
t’ = 20% in year 1.
› Afterwords, tax-rate returns to t = 25%. Then

PV lifetime income =
𝐷𝐷 1−𝑡𝑡′ 𝐷𝐷 1+𝑔𝑔 (1−𝑡𝑡) 𝐷𝐷 1+𝑔𝑔 2(1−𝑡𝑡)

+ + +… = $ 1.501.923
1+𝑖𝑖 1+𝑖𝑖 2 1+𝑖𝑖 3
› Lifetime income for temporary tax-cut

changes by 0,13%!
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Conclusion:
› Contrary to a permanent tax-cut, a temporary

tax-cut only changes the present value of life-
time income by 0.13%!
› If consumption is based on (expected) lifetime

income, temporary income changes will only
have a small effect on lifetime income, and
hence have a small effect on consumption
decisions.
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Modern Theory of Consumption

 This inter-temporal
approach to
consumption was
developed by Milton
Friedman and Franco
Modigliani.
 Each developed the

theory independently
and referred to it
using the names
permanent income
Milton Friedman Franco Modigliani
Nobel Laureate in and life-cycle income Nobel Laureate in
Economics respectively. Economics
1976 1985
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2. Optimal investment decisions

(see chapter 15)
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Optimal Investment Decisions

How do firms make their investments decisions?
 Investment projects typically run over multiple

periods.
 Thus, firms can not make decision based just on

current values of Y and i.
 Future profits should also be taken into consideration.
 So firms need to form expectations about those future

profits.
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A Firm’s Investment Decision

Consider the problem of a firm deciding on whether to buy a piece of
capital equipment.
• The immediate cost of buying the equipment is 𝑪𝑪𝒕𝒕
• If bought the machine will generate an expected future stream of

profits (per unit of capital):
𝒆𝒆 𝒆𝒆 𝒆𝒆
{𝚷𝚷𝒕𝒕+𝟏𝟏 , 𝚷𝚷𝒕𝒕+𝟐𝟐 , 𝚷𝚷𝒕𝒕+𝟑𝟑 ,⋯}
The investment decision should be based on a comparison of present

costs with future profits.
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Capital Depreciation
 Any piece of capital equipment is bound to depreciate
over time.
 Let 𝜹𝜹 denote the rate of depreciation of any piece of

capital.
 As the machine depreciates, the profits resulting from it

decrease.
 This implies that the stream of profits should be

𝒆𝒆 𝒆𝒆 𝒆𝒆
{𝚷𝚷𝒕𝒕+𝟏𝟏 , (𝟏𝟏 − 𝜹𝜹)𝚷𝚷𝒕𝒕+𝟐𝟐 , (𝟏𝟏 − 𝜹𝜹)𝟐𝟐 𝚷𝚷𝒕𝒕+𝟑𝟑 ,⋯}
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Present Discounted Profits

Let 𝑽𝑽(𝜫𝜫𝒕𝒕 ) denote the present discounted value of expected
future profits in real terms.
𝟏𝟏 𝟏𝟏
Then 𝑽𝑽 𝜫𝜫𝒕𝒕 𝒆𝒆 = 𝒆𝒆
𝚷𝚷𝒕𝒕+𝟏𝟏 + 𝒆𝒆
𝟏𝟏 − 𝜹𝜹 𝚷𝚷𝒕𝒕+𝟐𝟐 +⋯
𝟏𝟏+𝒓𝒓𝒕𝒕 𝟏𝟏+𝒓𝒓𝒕𝒕 𝟏𝟏+𝒓𝒓𝒕𝒕+𝟏𝟏 𝒆𝒆
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Aggregate Investment
 If this is how each firm makes its investment
decisions, then also for the aggregate level of
investment, 𝑰𝑰𝒕𝒕 , we should have,
𝑰𝑰𝒕𝒕 = 𝑰𝑰[(𝑽𝑽 𝚷𝚷𝒕𝒕𝒆𝒆 ]
where,𝚷𝚷𝒕𝒕𝒆𝒆 denotes the average expected profit per unit

of capital in the economy as a whole in every period.
 Thus, investment depends positively on the future

expected stream of profits and negatively on current
and expected real interest rates.
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Special case
› Assume the following special case (static expectations):
𝑒𝑒 𝑒𝑒
Π𝑡𝑡+1 = Π𝑡𝑡+2 = ⋯ = Π𝑡𝑡
and
𝑒𝑒 𝑒𝑒
𝑟𝑟𝑡𝑡+1 = 𝑟𝑟𝑡𝑡+2 = ⋯ = 𝑟𝑟𝑡𝑡
› Then the expected present discounted value is equal to:
Π𝑡𝑡
𝑉𝑉 Π𝑡𝑡𝑒𝑒 =
𝑟𝑟𝑡𝑡 + δ
› Where 𝑟𝑟𝑡𝑡 + δ is the rental cost of capital or user cost

of capital.
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Financial Constraints on Investment

Although in principle it is expected future profits that matter for
investment decisions,…
…in practice investment flows vary with current profit levels. Reasons:
1. Firms might be reluctant to borrow because investment might not

be as profitable as expected => firm might not be able to repay.
2. Banks might be unwilling to finance the investment: firm faces

borrowing constraints.
Hence in practice we have:

𝑰𝑰𝒕𝒕 = 𝑰𝑰[(𝑽𝑽 𝜫𝜫𝒕𝒕 𝒆𝒆 , 𝜫𝜫𝒕𝒕 ]
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Investment and profits

Figure 15-3 Changes in Investment and Changes in Profit in the
United States, since 1960
Investment and
profit move very
much together.
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Profitability
What determines profitability of an investment?
If 𝜫𝜫𝒕𝒕 corresponds to profits per unit of capital, then

𝒀𝒀𝒕𝒕
𝜫𝜫𝒕𝒕 = 𝜫𝜫
𝑲𝑲𝒕𝒕
 Given the size of the capital stock, current profit levels

increase with sales, which depend on 𝒀𝒀𝒕𝒕 .
 Current and expected output therefore affect

(expected) profits: 𝑰𝑰𝒕𝒕 = 𝑰𝑰 𝒀𝒀, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝒓𝒓𝒆𝒆
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Modern Theory of Investment

 Tobin argued that there should be a tight
relation between investment and the
value of the stock market.
 Firms compare the purchase price of an

additional unit of capital to the price the
stock market is willing to pay for it. If
the stock market value exceeds the
purchase price, the firm should buy the
machine; otherwise, it should not.
James Tobin
Nobel Laureate in
Economics
1981
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Consumption/Investment Parallel
Note the similarities between our treatment of consumption
and of investment behavior:
 Changes in consumption depend on whether consumers

perceive current changes in income to be transitory or
permanent.
 Changes in investment depend on whether firms

perceive current changes in sales to be transitory or
permanent.
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Consumption & Investment Volatility

Figure 16-5 Rates of Change of Consumption and Investment, in the
United States, since 1960
Relative movements
in investment are
much larger than
relative movements
in consumption.
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Consumption & Investment Volatility

The fluctuations of consumption and investment are
characterized by the following patterns:
 Consumption and investment usually move together.
 Consumption is less volatile than income.

Investment is much more volatile than income.
 In advanced economies, the level changes in

investment from one year to the next of the same
overall magnitude as the level changes in
consumption.
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3. Incorporating expectations in IS-LM

model
(see chapter 16)
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Expectations, Consumption & Investment
Expectations affect consumption and investment decisions,

both directly and through asset prices.
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Expectations-Augmented IS Curve
 The standard form of the IS curve does not
incorporate expectation effects.
 Income is only affected by contemporaneous changes

in exogenous variables:
𝒀𝒀 = 𝑪𝑪 𝒀𝒀 − 𝑻𝑻 + 𝑰𝑰 𝒀𝒀, 𝒓𝒓 + 𝒙𝒙 + 𝑮𝑮
 If consumption and investment decisions are forward-

looking, then future values should also matter:
𝒀𝒀 = 𝑪𝑪 𝒀𝒀 − 𝑻𝑻, 𝒀𝒀𝒆𝒆 − 𝑻𝑻𝒆𝒆 + 𝑰𝑰 𝒀𝒀, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝒓𝒓𝒆𝒆 + 𝑮𝑮

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 If consumption and investment decisions are forward-
looking, then future values should also matter:
𝒀𝒀 = 𝑪𝑪 𝒀𝒀 − 𝑻𝑻, 𝒀𝒀𝒆𝒆 − 𝑻𝑻𝒆𝒆 + 𝑰𝑰 𝒀𝒀, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝒓𝒓𝒆𝒆 + 𝑮𝑮
 To simplify let’s define aggregate private spending as:
𝑨𝑨 𝒀𝒀, 𝑻𝑻, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝑻𝑻𝒆𝒆 , 𝒓𝒓𝒆𝒆 = 𝑪𝑪 𝒀𝒀 − 𝑻𝑻, 𝒀𝒀𝒆𝒆 − 𝑻𝑻𝒆𝒆 + 𝑰𝑰 𝒀𝒀, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝒓𝒓𝒆𝒆
 Then we can rewrite the expectations-augmented IS

curve as:
𝒀𝒀 = 𝑨𝑨 𝒀𝒀, 𝑻𝑻, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝑻𝑻𝒆𝒆 , 𝒓𝒓𝒆𝒆 + 𝑮𝑮
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 Then we can rewrite the expectations-augmented IS
curve as:
𝒀𝒀 = 𝑨𝑨 𝒀𝒀, 𝑻𝑻, 𝒓𝒓, 𝒀𝒀𝒆𝒆 , 𝑻𝑻𝒆𝒆 , 𝒓𝒓𝒆𝒆 + 𝑮𝑮
 For each of the included variables the relationship

between aggregate private expenditure must be that:
𝒀𝒀 ↑ 𝒐𝒐𝒐𝒐 𝒀𝒀𝒆𝒆 ↑⇒ 𝑨𝑨 ↑
𝑻𝑻 ↑ 𝒐𝒐𝒐𝒐 𝑻𝑻𝒆𝒆 ↑⇒ 𝑨𝑨 ↓
𝒓𝒓 ↑ 𝒐𝒐𝒐𝒐 𝒓𝒓𝒆𝒆 ↑⇒ 𝑨𝑨 ↓
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 Like the original IS curve
the expectations-
augmented IS curve is
downward slopping.
 Note how the new IS

curve shifts from
changes in exogenous
variables as well as 𝒀𝒀𝒆𝒆
and 𝒓𝒓𝒆𝒆 .
 The new IS curve is more

steep than the original
one.
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The greater steepness of the new IS curve implies that a
large decrease in the current interest rate is likely to
have only a small effect on equilibrium income. This is
because:
1. 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.
2. Size of the multiplier: if changes in income are not

expected to last, they will have a limited effect on
consumption and investment.
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The Unchanged LM Curve

› As expectations about future nominal interest rates do
not affect current interest rates, the LM curve does not
need to be modified:
𝒓𝒓 = 𝒓𝒓�
› Combining the new IS with the unchanged LM we can

identify the short-run equilibrium of the economy.
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The New IS-LM System

 The new IS-LM system
behaves like the
original one.
 The IS-LM intersection

pins down the short-
run equilibrium.
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4. Revisiting Monetary Policy

(see chapter 16)
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Monetary Policy Revisited

Starting from
an equilibrium
at point A, a set
of expansionary
monetary
policies are
introduced.
Apart from a
shift of the LM
curve this might
trigger an
adjustment of
expectations.
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Monetary Policy Revisited

The ultimate effects of an expansionary monetary policy
on output will depend crucially on its effect on
expectations of households and firms:
 If economic agents expect that lower interest rates

and higher output are permanent, then the effect of
a monetary expansion on output will be large.
 If economic agents expect that lower interest rates

and higher output are temporary, then the effects of
a monetary expansion on output will be small.
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5. Revisiting Fiscal Policy

(see chapter 16)
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Fiscal Policy Revisited

Starting from an initial
equilibrium, a set of
contractionary fiscal
policies are introduced.
The first effect of this will

be a leftward shift of the
IS curve.
Following that, though, an

adjustment of
expectations will might in.
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Direct effect:
 Current government spending goes down, shifting the IS

curve to the left.
However, taking into account expectations, a contractionary fiscal

policy does not necessarily lead to a decrease in short-run
output.
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Last year, you learned that output returns to the natural level of
output in the medium run. As a result, we can deduce the
following indirect effects:
 If output returns to its natural level, then lower future gov’t

spending implies higher future investment. Higher investment
implies lower future interest rates, shifting the IS-curve to
the right today.
 Higher future investment increases capital accumulation,

thereby raising the natural level of output. Hence expected
future output goes up, shifting the IS curve to the right
today.
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 Lower future gov’t spending reduces future taxes. Hence

consumers’ lifetime income goes up, and the IS-curve shifts
outwards.
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This implies two possible outcomes.
A. Conventional Belt-Tightening Contraction:

The lower government spending reduces aggregate demand and
output via the multiplier. Counterbalancing expectation effects
only partially offset that.
B. Expansionary Fiscal Contraction:

Expectation of lower interest rates and higher output in the future
lead to a large expansion of consumption and investment
spending today that completely reverses the fall in aggregate
demand due to lower government spending.
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Important determinants whether contractionary fiscal policy is
expansionary or not:
› Timing: smaller cuts today have smaller adverse effect on

spending today but might affect credibility of the policy.
› Composition: is deficit reduction achieved through higher taxes

or lower spending? Does it remove distortions?
› Initial situation: if government finances are in dire situation,

government might not have much choice.
› Monetary policy: can (partially) shift the IS-curve to the right if

(future) rates are expected to be lower.
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Fiscal Contractions at the ZLB

Key channel of expansionary fiscal contraction is lower
future interest rates.
 When the economy is stuck at the ZLB, (future)

interest rates cannot decrease!
 The logic behind expansionary fiscal contractions does

not apply.
 In fact, fiscal contractions amplify economic contractions,

as the IS-curve shifts further to the left.
 For a small member of a monetary union, it is as if the

country is effectively at the ZLB.
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Fiscal Contractions at the ZLB

Greece: a small member of a Monetary Union
(MU) is effectively at the ZLB.
Source: Bruegel.
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This week….
 We extended the traditional IS-LM model by
incorporating expectations about the future.
 The study of economic policy with the expectations-

augmented IS-LM model becomes more complex.
 Expectations effects may counterbalance or reverse

the policy effects from the traditional IS-LM model.
 This makes the predictions of policy effects less

clear-cut and subject to different interpretations.

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faculty of economics

(Chapters 15 & 16)

› We learned about arbitrage and how to infer the yield-to-

› We learned how to price stocks, and the effects of

› For that purpose, we revisit:

 Optimal investment decisions.

› We investigate how including expectations affect monetary

Expectations in the IS-LM Model

Expectations in the IS-LM Model

Expectations in the real world

Consequence: expectations of lower future interest

› “ECB expands purchases to include bonds issued

› “Combined monthly asset purchases to amount to

Expectations in the real world

Analyze optimal investment decisions.

Present the expectations-augmented IS-LM model.

Discuss the implications for economic policy.

1. Optimal consumption decisions

Optimal Consumption Decisions

 Consumers should look at their whole life-cycle and

 Then they should use a share of their lifetime wealth

Optimal Consumption Decisions

› Consumer would add:

› Consumer would decide how much to spend out of total

› If the demanded level of consumption is larger than current

Optimal Consumption Decisions

1. People might not want constant life-time consumption.

2. Amount of computation and foresight involved in

3. Computation is based on expectations, which might

4. Credit constraints: banks might not be willing to lend

Optimal Consumption Decisions

› To capture this, we write:

𝑪𝑪𝒕𝒕 = 𝑪𝑪 𝑾𝑾𝒕𝒕 , 𝒀𝒀𝒕𝒕 − 𝑻𝑻𝒕𝒕

Example: borrowing constraints

Note how the effect

Example lifetime income: tax-cuts

› Consumption today depends on lifetime

› As an illustration, we compare the effect on

Example lifetime income: tax-cuts

› Annual income at the start: D = $40.000.

› Income growth: g = 2% per year.

› Constant nominal interest rate: i = 4% per year.

› Initial tax rate t = 25%.

› Assume person lives forever (this simplifies the

Example lifetime income: tax-cuts

𝐷𝐷 1−𝑡𝑡 𝐷𝐷 1+𝑔𝑔 1−𝑡𝑡 𝐷𝐷 1+𝑔𝑔 2 1−𝑡𝑡

› Assume a permanent tax-cut from t = 25% to t’

𝐷𝐷 1−𝑡𝑡′ 𝐷𝐷 1+𝑔𝑔 (1−𝑡𝑡′) 𝐷𝐷 1+𝑔𝑔 2(1−𝑡𝑡′)

› Lifetime income changes by 6,7% for permanent

Example lifetime income: tax-cuts

› Afterwords, tax-rate returns to t = 25%. Then

𝐷𝐷 1−𝑡𝑡′ 𝐷𝐷 1+𝑔𝑔 (1−𝑡𝑡) 𝐷𝐷 1+𝑔𝑔 2(1−𝑡𝑡)

› Lifetime income for temporary tax-cut

Example lifetime income: tax-cuts

› Contrary to a permanent tax-cut, a temporary

› If consumption is based on (expected) lifetime

Modern Theory of Consumption

 Each developed the

2. Optimal investment decisions

Optimal Investment Decisions

 Investment projects typically run over multiple

 Thus, firms can not make decision based just on

 Future profits should also be taken into consideration.