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 - p^e
  • 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 p^e and future p'^e)

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

• Y = A(Y,T,r,Y^e,T^e,r^e) + 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)