Chapter 17:

Expectations, Output and Policy

We have seen that expectations affect consumption and
investment. The channels:

Future labour income

(Human and nonhuman

wealth)

Future interest rates

Future profits
Can we modify the standard IS-LM model
to take expectations into account?
Remember the IS equation:

𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝑥 + 𝐺

To simplify notation, define private spending A, as:

𝐴 𝑌, 𝑇, 𝑟, 𝑥 ≡ 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑟 + 𝑥

The IS relation becomes:

𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑥 + 𝐺
(+, −, −, −)

So far, nothing has changed. Just change in notation…

q Aggregate spending increases with Y: higher Y increases
consumption and investment

q Aggregate spending decreases with T: higher T reduces

consumption

q Aggregate spending decreases with r: higher r reduces

investment

q Aggregate spending decreases with x: higher x reduces

investment
 𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑥 + 𝐺

The easiest way to incorporate expectations is to extend private

spending to:

𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑌 !" , 𝑇 !" , 𝑟 !" + 𝐺

(+,−,−, +, −, −)

Variables with ‘ are future variables and are expected. Assume x

is constant and eliminate it.
 𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑌 !" , 𝑇 !" , 𝑟 !" + 𝐺
(+,−,−, +, −, −)

Let’s understand the signs….

q Higher income today (Y) or tomorrow (Y’e) increases private spending

today.

1. Consumption increases
(higher present or future labor income)

2. Investment increases
(higher future profits)

q Higher taxes today (T) or tomorrow (T’e) reduce private spending today.

1. Consumption decreases
(lower present or future labor income)
 𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑌 !" , 𝑇 !" , 𝑟 !" + 𝐺
(+,−,−, +, −, −)

q Higher interest rates today (r) or tomorrow (r’e) decrease private

spending today.

1. Consumption decreases
(future labor income is worth less. PDV is reduced)

2. Investment decreases
(future profits are worth less. PDV is reduced)
 𝑌 = 𝐴 𝑌, 𝑇, 𝑟, 𝑌 !" , 𝑇 !" , 𝑟 !" + 𝐺
(+,−,−, +, −, −)

q Plot the curve in a diagram with Y and r on the axes

q Changes in current interest rate (r): movements along the curve

q Increases in current and expected taxes (T and T’e) and expected interest rates (r ’e)
shift the IS to the left.

q Increases in expected production (Y’e) and current government spending (G) shift the
IS to the right.
q The IS curve is steeper than before, why?

Ø If expectations don’t change, the current interest rate

does not affect spending a lot: small changes in PDV.

Ø If expectations don’t change, multiplier is smaller

(a change in output has a smaller effect on consumption and
investment).

The IS changes
significantly!
 Monetary Policy, Expectations, and Output

The Fed affects directly the current real rate (r): LM horizontal
line at 𝑟:̅

𝑟 = 𝑟̅
The effects of monetary policy depends on its effects on
expectations:

- If a monetary expansion leads to changes in expectations

of future interest rates and output, then the policy effect
on output may be large.
- But if expectations remain unchanged, the policy effects on
output will be limited.
 Monetary Policy, Expectations, and Output

The IS curve is steeply

downward sloping. Other
things being equal, a
change in the current
interest rate has a small
effect on output. Given the
current real interest rate
set by the central bank, 𝑟̅ ,
the equilibrium is at point
A.
 Monetary policy

Assume that the Central Bank decreases 𝑟.

No changes in expectations: from A to B.

The effects of monetary policy on

output depend very much on
whether and how monetary policy
affects expectations.

Only LM shifts from LM to LM’’.

Small effect on output (from A to
B)!
 Monetary policy

Assume that the Central Bank decreases 𝑟.

Changes in expectations: markets expect lower interest rates

and higher output in the future: IS shifts (from A to C).

The effects of monetary policy on

output depend very much on
whether and how monetary policy
affects expectations.

LM shifts down AND IS shifts to

the right!
Main lesson:

q Effects of monetary (and also fiscal, as we will see…) policy

depends on expectations.

q In particular, if policy-makers are able to modify

consumers’/firms’ expectations, then the effects of monetary
policy on output could be bigger.

q CRUCIAL FOR POLICY-MAKERS!

 Fiscal Policy and Expectations

Consider a plan to reduce public deficit, G-T (lower G or higher T)

ØLet’s start from the natural level 𝑌# .

ØWe know that the IS shifts to the left.

Ø In the short-run, this leads to lower Y.

Governments care a lot about short-run (to stay there,
politicians need to win elections!), so they won’t be happy
with deficit reduction, as it reduces output (and increases
unemployment) and reduces their chances to be re-elected.

Can the management of expectations make deficit reduction

more appealing in the short-run? YES!
 Deficit Reduction, Expectations, and Output
The Effects of a Deficit Reduction on Current Output

When we consider the effect on

expectations, the decrease in
government spending need not lead
to a decrease in output.

3 effects on the IS curve SHORT-RUN

1. No effects on expectations, only

ΔG, this reduces output.

2. Effects on 𝑌 " : output could

increase.

3. Effects on 𝑟 " : output could

increase.
Let’s see the chain of events:

1. Short-run: IS to the left. Lower Y.

2. Medium-run: output back to 𝑌# , thanks to monetary policy. Y

as before, r lower. Higher savings, higher investment.

3. Long run: higher investment translates into higher capital

and, thus, higher output.

4. When people expect these effects, then output can increase

right now.
 Deficit Reduction, Expectations, and Output
q Assume that G (present) and/or G’e (future) decrease (the government plans
and announces to reduce the deficit over time).

q SHORT RUN: let us start from 𝑌# . IS to the left. Lower Y.

q MEDIUM-RUN: inflation is decreasing. Monetary policy reduces r.

𝑌 goes back to 𝑌# and the interest rate is lower (LM shifts down to obtain the
same level of output). People expect lower re. Government spending is lower.

q … then investment has to be higher…

q Lower re causes higher expcted investment and this leads to higher capital
stock in the LONG RUN. People expect higher Y in the long run: 𝑌 " increases.

q When people expect these effects, then output can increase right now.
When people forecast what is happening in the LONG RUN, they will
expect:

higher Y’e and lower r’e

1. Lower G (or higher T) TODAY shifts the IS to the LEFT.

2. Higher Ye and lower re, in expectation of future movements, will shift

the IS to the RIGHT!

What is the overall effect on Y and r TODAY?

Can expectations overturn the negative effect on Y even in the short-run?

The overall effect is hard to predict without further information, but in
principle, output can increase today.
The overall effect depends on the details of the deficit reduction
plan:

Ø A larger reduction in future spending, Ge (or increase in

future taxes, Te) will probably have a bigger impact on
expectations today (backloading) and does not shift the IS to the
left today.

Ø On ther other hand, backloading raises issue of lack of

credibility: will the government do what promised today?
Let us summarize:

A program of deficit reduction may increase output in the short run.

Ø Credibility of the program. Will spending be cut and taxes be increased in

the future, as announced?

Ø Timing of the program. How large are spending cuts (tax increases) in the
future relative to current spending cuts (tax increases)?

Ø Composition of the program. Does the program remove some of the

distortions in the economy (i.e. lowering unemployment benefits
increases 𝑌# )? This will enhance expectations about the future.

Ø State of government finances. How large is deficit? Is this a «last chance»

program? This could reassure markets, decrease the pessimism of agents
and stimulate the economy in the short run.

Ø Monetary policy. Even if monetary policy cannot fully offset the effect of
an adverse shift in the IS curve, a decrease in the policy rate can help
reduce the adverse effects of the shift on output.
 Can a Budget Deficit Reduction Lead to an Output Expansion? Ireland
in the 1980s

• In 1982, Ireland started a deficit reduction program that focused on tax increases but
did not change what people saw as too large a role of government in the economy,
resulting in high deficits and low GDP growth (1st effect wins)

• In 1987, Ireland’s deficit reduction program with a focus on cuts in spending and tax
reform that had a positive impact on expectations, resulted in higher output growth
(2nd+3rd effects).

Fiscal and Other Macroeconomic Indicators, Ireland, 1981 to 1984, and 1986 to 1989
 Deficit Reduction, Expectations, and Output
$%
• Different views about the fiscal multipliers ($& , the net effects
of fiscal consolidation once direct and expectation effects are
taken into account):

– Those in favor of strong fiscal consolidation argue that fiscal multipliers

$%
are likely to be negative $& < 0, and thus smaller deficits would lead to
an increase in output (austerity fans….believers in effects 2 and 3)

– Those against strong fiscal consolidation argue that fiscal multipliers are
$%
likely to be positive and possibly large $& > 0, thus smaller deficits
would lead to a decrease in output (believers in effect 1).
 Deficit Reduction, Expectations, and Output
Growth Forecast Errors and Fiscal Consolidation in Europe, 2010−2011

European countries with stronger

fiscal consolidations in 2010 and
2011 had larger negative growth
forecast errors (expected larger
output than what realized).

Multiplier is positive! Effect 1 is

strong! Reducing G has a
negative effect on Y.

Austerity fans forced countries to

have fiscal consolidations, but
output growth was lower than
expected.