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 [1]
Subject X2:
Economics [1]