# WEEK VI Expectations. W EEK VI Expectation and uncertainty Expectation is what is considered the most likely to happen in the condition of uncertainty.

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WEEK VI Expectations

W EEK VI Expectation and uncertainty Expectation is what is considered the most likely to happen in the condition of uncertainty. Uncertainty comes from having limited knowledge where it is impossible to exactly describe the future outcome Expectations relate to a ‘belief’ that may or may not be true. Economic decisions depend not only on what is happening today but also on expectation of what will happen in the future We have informally discussed expectation in form of expected price in real wage determination Expected price/inflation affect most economic decisions such as interest rate Nominal vs real interest rate Nominal interest rate is the interest rate in terms of dollars, while real interest rate is in term of a basket of goods (purchasing power)

W EEK VI Definition and derivation of real interest rate

W EEK VI Where : i t : nominal interest rate at year t r t : real interest rate at year t P t : price level at year t P e t+1 : expected price level at year t+1  e t+1 : expected inflation rate between year t and year t+1

W EEK VI The exact relationship between real and nominal interest rate (above) can be simplified into approximation (if i and  e t+1 < 20%): Implications of equation: 1.  e t+1 = 0  r t = i t 2.  e t+1 > 0  r t < i t 3.  e t+1   r t  ex-ante vs ex-post ex-ante (‘before the fact’) is based on expectation (e.g. i t -  e t+1 ) ex-post (‘after the fact’) is based on actual (e.g. i t -  t+1 )

W EEK VI Interest rate and IS-LM Model Intuitively, investment (I) decision depends on real interest rate (r) thus IS relation should be modified: IS: Y = C(Y – T) + I(Y, r) + G While opportunity cost of holding money (Md) is dependent on nominal interest rate paid by bonds: LM: (M/P) = Y, L(i) For this reason, the extended IS-LM Model adds: r = i t -  e that has implications: 1.Interest rate indirectly affected by monetary policy (nominal interest rate in LM relation) 2.Real interest rate affects spending and output (IS relation) 3.The effects of monetary policy on output depend on  e.

W EEK VI IS-LM Model: Revisit IS: Y = C(Y – T) + I(Y, i -  e ) + G LM: (M/P) = Y, L(i)

W EEK VI Effect of expansionary monetary policy

W EEK VI In the short-run: expected inflation is constant thus: 1.Ms   (M/P)  i  (and r  )  (adjustment process IS & LM)  Y  2.LM curve shifts from LM to LM’ Over time (medium & long run) 1.Output, Y, returns to the natural level of output Y n 2.The value of real interest rate relates to Y n : natural real interest rate: r n 3.r n is independent on monetary policy 4.Rate of inflation = rate of money growth i = r +  e i = r +  i = r n + g M Interpretation of the equation: Money growth will not affect the real interest rate but affects the nominal interest rate and its changes one- for-one with inflation rate (Fisher effect/hypothesis).

W EEK VI Expectations in consumption and investment C and I are main components of demand/spending Consumption C = C(Y) Forward-looking consumption theory: Permanent income theory of consumption – Milton Friedman Life cycle theory of consumption – Franco Modigliani Where: Wealth = human and non human wealth (financial and housing wealth)

W EEK VI Directly, expectation affect Consumption through human wealth in which consumers need to expect about future labor income, real interest rates and taxes Indirectly, expectation affect consumption through non human wealth in term of stocks, bonds, housing – given Implications of effect of expectation on consumption: 1.Consumption is likely to respond less than one-for-one to fluctuations in current income (Y) 2.Consumption may move even if current income does not change (due to changes in consumers’ expectation in the future)

W EEK VI Investment Investment decision is not only dependent on Y and r but expectation in the future Net present value (NPV): comparison present value of expected profits stream and current costs: NPV > 0  Invest; NPV < 0  Not invest  : depreciation rate of capital (e.g. machine)

W EEK VI Present value of expected profits stream from purchasing machine over time: Assume that real price of machine = 1; therefore V(  e t ) > 1  purchase machine; while V(  e t ) < 1  Not purchase machine From individual firm’s investment decision to aggregate: Interpretation: Investment positively depends on expected present value of future profits (per unit of capital).

W EEK VI To simplify, assume that expectation = present (variable  and r) or static expectation, thus present value of expected profit: And investment function: Where (r t +  ) : user cost or rental cost of capital Interpretation: investment depends on the ratio of profit to the rental cost. The higher the profit, the higher level of investment but the higher rental cost, the lower level of investment.

W EEK VI Role of expectation make C and I are volatile: C and I usually move together I is much more volatile than consumption Since contribution (to GDP) of C (70%) > I (15%) thus both components contribute equally to fluctuations in output/GDP over time Expectations: Effect of Fiscal and Monetary Policies

W EEK VI Expectations: IS relation C & I depends on expectation of the future IS: Y = C(Y – T) + I(Y, r) + G Where A: private spending (C + I) Taking account the role of expectations:

W EEK VI Extended IS curve: role of expectations

W EEK VI Extended IS curve: 1.Has a negative slope (relationship between r and Y) 2.Much steeper: ceteris paribus, r   Y  in which  r >  Y (Since the expectations of r and Y in the future do not change, they do not lead to large changes in spending i.e. I and C) Shifts of IS curve: 1.Due to changes in T and G 2.Due to changes in expected future variables Expectations: LM relation Role of expectation has no effect on LM relation because the decision to hold money (Md) depends on current instead of future Y and i. LM relation keeps the same:

W EEK VI Extended IS-LM Model: Role of expectations LM relation uses current nominal interest rate (i) but IS relation uses current (r) and expected (r e ) real interest rate Adjustment: Current real interest rate: r = i -  e Expected future real interest rate: r’ e = i’ e -  ’ e M   i   r and r’ e ? depends on: 1.Expected future nominal interest rate: i’ e 2.Expected current inflation:  e and expected future inflation:  ’ e Assume we concern on expected future nominal interest rate (i’ e ) and ignore role of expectation of inflation (  e and  ’ e ) thus i = r. With this simplification (i = r)

W EEK VI Extended IS-LM model: Equilibrium

W EEK VI Effect of expansionary monetary policy: If expected Y and r are constant therefore Y A  Y B If expected Y  and expected r  thus Y A  Y C Monetary policies: adjust r and manage expectations (investors, firms and consumers)

W EEK VI Effect of a deficit reduction of fiscal policy: If expected Y and r are constant therefore Y  If expected Y  and expected r  thus Y  (recall: crowding in and crowding out)

W EEK VI How to manage positive expectations: The credibility of policy/program (e.g. moral suasion) The transparency of policy/program The accountability of policy/program

W EEK VI