CHAPTER
17
Expectations,
Output, and Policy
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
How Do Expectations Influence 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 policies affect expectations
about future policy.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
How Do Expectations Influence Output and
the Effects of Monetary and Fiscal Policy?
 This chapter ties together the material on
expectations by incorporating expectations
into the IS-LM model.
 It introduces rational expectations and
allows relatively sophisticated discussion of
the effects of monetary and fiscal policy.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and
Decisions: Taking Stock
17-1
Expectations and
Spending: The
Channels
Expectations affect
consumption and
investment
decisions, both
directly and
through asset
prices.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations, Consumption,
and Investment Decisions
 Think about time in terms of two periods: the
“present” and the “future,” (which lumps all
future years together; denoted by an
apostrophe).
 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations, Consumption,
and Investment Decisions
– Earlier, the IS relation was:
Y  C (Y  T )  I (Y , r )  G
 Define aggregate private spending, A, as:
A (Y , T , r )  C (Y  T )  I (Y , r )
 Rewrite the IS relation as:
Y  A (Y , T , r )  G
( ,  ,  )
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
 The Current Period IS curve is
Y  A (Y , T , r )  G
( ,  ,  )
but it ignores expectations
Incorporating the role of expectations,
e
e
e
Y

A
(
Y
,
T
,
r
,
Y
'
,
T
'
r
'
) G
then:
(  ,  , + ,  ,  )
Primes denote future values, and es expected values.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
Y  A (Y , T , r , Y ' , T ' r ' )  G
e
e
e
(  ,  , + ,  ,  )
 The positive and negative signs indicate
that:
Y or Y '
e


A
T or T '
e


A ↓
r or r '
e


A
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
 Is the new, more sophisticated IS curve
steeper or flatter than the old IS curve?
– Suppose r rises, but r’e stays the same.
– So investment will become more expensive
this period, but equally expensive next
period.
 This is different than in chapter 5, where a change
in r was interpreted as a “permanent” change.
Vt  $ zt 
1
(1  r t )
© 2003 Prentice Hall Business Publishing
$z 
e
t
1
$ z t  2  ...
e
(1  r t )( 1  r t  1 )
e
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
 Is the new, more sophisticated IS curve
steeper or flatter than the old IS curve?
– Investment projects take several years to
complete, requiring several years of
borrowing.
 A change in r that doesn’t change r ’e is a
“temporary” change.
– Then a change in the cost of borrowing that
affects only one year impacts investment less
than a permanent change.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
 The new IS curve is relatively steep.
 A large decrease in the current interest
rate is likely to have only a small effect on
equilibrium income:
– 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.
 Suppose r = 3% for t+1, … .
 What is the effect of r = 2% today and then rising
back to 3%, forever?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
– 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.
 Suppose General Motors’ I rises because r fall; but
they are both expected to go back to normal
tomorrow.
 Will GM’s suppliers increase their capacity?
 Will GM’s workers increase their consumption
significantly?
– Conclusion: A large decrease in the current
interest rate is likely to have only a small effect
on equilibrium income.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Expectations and the IS Relation
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 future output, shift
the IS curve to the right.
Increases in taxes,
 Yt in
 or in
 t future
  taxes,
expected
 K t real
the expected future
interest rate shift the IS
curve to the left.
© 2003 Prentice Hall Business Publishing
Assume, for now,
p = pe = 0, so r = i
Macroeconomics, 3/e
Olivier Blanchard
The LM Relation Revisited
 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
P
 YL ( i )
 The interest rate that enters the LM relation is
the current nominal interest rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
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
upward sloping. The
equilibrium is at the
intersection of the IS
and LM curves.
IS : Y  A ( Y , T , r , Y ' , T ' , r ' )  G
e
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e
e
LM :
Macroeconomics, 3/e
M
P
 YL ( r )
Olivier Blanchard
Monetary Policy,
Expectations, and Output
17-2
 An increase in the money supply decreases
the current nominal interest rate in the SR.
The amount by which the interest rate
decreases depends on:
– How financial markets revise their expectations
of the future nominal interest rate, i’e.
– How financial markets revise their expectations
of both current inflation, pe, and future inflation,
e
e
e
e
p’e.
r = i- π
r ' = i' - π'
© 2003 Prentice Hall Business Publishing
Assume, for now,
p = pe = 0, so r = i
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
The Effects of an
Expansionary
Monetary 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Suppose money supply grows faster (gm
rises) and r falls:
 We’re still assuming pe = 0.
– If r’e falls, IS shifts and Y rises much.
– If r’e does not fall, IS doesn’t shift and Y doesn’t
rise much.
 r’e won’t fall if people know the reasoning of Chapter
14: when gm rises, r falls in the short run but goes
back to r = rn in the medium run.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Everything depends on expectations, so
anything can happen. Economics is not a
science and predictions are useless.
 False: expectations aren’t random. People
form expectations of future events based on
some process of reasoning.
– We can survey the financial markets and find
out what kind of model (or reasoning) they
follow.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Rational expectations:
– People do the best they can to work out the
implications of an economic policy, given their
knowledge of the workings of the economy and
the available information.
 Typically, we assume that people aren’t stupider than
the economist writing the model, so they “know” the
economist’s model.
– The alternative is to assume that people
routinely make the same mistakes.
 Of course, they often do.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Until the 1970s, economists thought of
expectations as:
– Animal spirits—the Keynesian treatment of
expectations: important but unexplained.
– Backward-looking rules—either static or
adaptive expectations (expectations adjust to
past events).
 The assumption of rational expectations is
one of the most important developments in
macroeconomics in the last 25 years.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Keynes suggested three “rules of thumb” for
expectations formation:
– Assume that the past is a good guide for the
future, unless something suggests the opposite.
– Assume that current prices and output are
based on a correct forecast.
– Assume that the general consensus is correct.
 This means expectations are “based on so flimsy a
foundation [they are] subject to sudden and violent
changes.” (Keynes 1937)
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy,
Expectations, and Output
 Keynesian ideas about the formation of
expectations (whether animal spirits or
adaptive expectations) went out of fashion in
academic circles in the late 1970s.
 But they are very relevant, so they never
lost importance in the financial markets.
 Today academicians are bringing both
insights together, trying to figure out how
reasonable people make consistent
mistakes.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction,
Expectations, and Output
17-3
 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
output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction,
Expectations, and Output
 In the medium run, Y=Yn.
 Even if the deficit is reduced, spending is
the same.
 But if G falls and T rises, I must rise for
spending to be the same.
 I rises in the medium run because r falls.
 In the long run, if I rises, the level of output
rises.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Back to the Current Period
 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.
– Expected future output goes up and r’e goes
down—the IS curve shifts to the right.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Back to the Current Period
The Effects of a
Deficit Reduction on
Current Output
When account is taken
of its effect on
expectations, the
decrease in
government spending
need not lead to a
decrease in output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Back to the Current Period
 Suppose the administration wants to cut the
deficit.
– Cutting expenditure means fewer projects that
benefit legislator’s constituencies; higher taxes
are often unpopular.
 The administration can “defer the pain” of
the deficit reduction by cutting a little today
and leaving bigger cuts for tomorrow.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Back to the Current Period
 Small cuts in government spending and
large expected cuts in the future will cause
output to increase more in the current period
than without the promise!
 This is 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Back to the Current Period
 To summarize, the change in output as a
result of deficit reduction depends on:
– People’s knowledge of our models of economic
growth.
– People’s patience (do they care about Y’e?).
– The credibility of the program
– The timing of the program
– The composition of the program
– The state of government finances in the first
place.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
A Supply-Side Word
 This conclusion (basically Clinton-Rubin’s)
says that raising taxes raises growth, both in
the long run and in the short run!
 But I should also depend on Taxes.
– Income taxes reduce entrepreneur’s incentives;
– Business taxes, including tariffs, fees, etc., make
projects less profitable;
– Some regulations make investment less
attractive.
 So cutting T and cutting G by more may be a
better option.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard