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Expected Policy

IS-LM model w/ expectations  

  • IS curve in terms of real interest (both current and expected), while LM curve still uses nominal interest (only current)
    • r = i - pe
    • r'e = i'e - p'e (future expected values)
  • effects of money supply increase depends on whether financial markets change i'e (expected future interest) and inflation rates (both current pe and future p'e)

simplified case w/ no inflation >> real interest rate equals nominal interest rate  

  • Y = A(Y,T,r,Ye,Te,re) + G
  • M/P = Y L(r)
  • given an expansionary monetary policy, both IS and LM curves shift
    • LM curve shifts down >> small change in output initially
    • lower expected interest (from LM shift) increases spending/output >> IS curve shifts to the right >> output increases more
    • expansionary policy creates shifts in both IS and LM when taking expectations into account

 

  • IS relation
  • LM relation
  • LM relation initially shifts down due to monetary expansion
  • markets expect lower interest >> investment increases >> output increases >> IS relation also shifts to the right to final equilibrium

effects of deficit reduction - G decreases  

  • beneficial in medium/long run (higher savings/investment in medium run >> higher capital/output in long run)
  • may also increase output in short run >> if ppl take into account future benefits
    • doesn't always decrease output
  • w/o expectations, IS curve shifts to the left (as G decreases)
    • expected decreased interest rate >> increases investment
    • return to natural output in medium run >> private spending (Y) increases to make up for decrease in public spending (G)
    • expected future output increases, expected future interest decreases >> IS curve shifts back to the right
  • backloading - smaller cuts currently and larger cuts in the future >> more likely to increase current output
    • would also decrease credibility (perceived ability of gov't to do what it needs to) if public thinks situation will get worse (w/ larger cuts)
    • ppl already expecting bad economic/political trouble >> may increase credibility w/ gov't starting budget cuts (shows gov't getting control of situation)
Subject: 
Economics
Subject X2: 
Economics

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