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A selection from the textbook 'macroeconomics: a european perspective' by blanchard, amighini and giavazzi. It discusses the role of expectations in the is relation and the lm relation, as well as the effects of fiscal policy. The authors explore how changes in current and expected future labor income, real interest rates, and government spending impact consumption and investment through expectations and wealth effects.
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Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Figure 17.
Expectations and spending: the channels
Expectations affect consumption and investment decisions, both directlyand through asset prices
a) Expectations and the
IS
Relation
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
-^
-^
-^
-^
Expectations, Wealth, Consumption and Investment
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
-^
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Expectations and the
Relation
curve to the right.
in
taxes,
in
expected
future taxes or in the expected futurereal interest rate shift the
IS
curve to
the left.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
where
-^
e^
represents the expected (present) value of consumers’ lifetime
wealth, which depends on current wealth, expected future incomes,future taxes, current and future interest rates and dividends, etc. •^
eV represents
the
expected
present
value
of
(after-tax)
future
profits.
The “new”
IS
relation
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
IS:
Y= Y( r ; G, T, W
e F
, V
e F
)
LM:
r = r( Y ; M, P,
π
e)
IS-LM
equilibrium
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
-^ with a higher expected inflation, the downward shift of the LM and thedecrease in r will be larger; •^ with the expectation of lower future interest rates or higher future output,the IS will also shift to the right.
c) Monetary policy revisited
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Rational Expectations
-^ If the effects of policies or other shocks depend so much on expectations, is thereany hope of predicting what will happen? - Yes, expectations are not arbitrary! - Until the 1970s, macroeconomists thought of expectations as: -^ Animal spirits - the Keynesian treatment of expectations, which considers them
important but unexplained.• Backward-looking rules—either static or
adaptive expectations
(based on past
experience, revised according to errors).
-^ Rational expectations revolution
: expectations are
forward-looking
(Lucas, Sargent)
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
-^
→
IS
(and AD) shift to the left
→
contractionary effects on output.
→
higher capital stock
→
higher output,
i.e. higher future income, lower future taxes (IS shift to the right). –^ Taking into account future benefits, therefore, a budget deficit reductioncould also have positive benefits in the short run!
d) Fiscal Policy revisited
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Back loading
the deficit reduction toward the future, with small
cuts in the present and larger cuts in the future is more likely tolead to an increase in output.
-^
Back loading, however, may decrease the credibility of the deficitreduction program, leaving most of the reduction for the future,not the present.
-^
The government must balance: enough cuts in the current periodto show a commitment to deficit reduction and enough cuts left tothe future to reduce the adverse effects on the economy in theshort run.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Anything that improves expectations about the future, makes deficitreduction programme less painful:•^
Measures
reducing
distortions
in
the
economy
(tax
distortions,
inefficiencies in social security, unemployment benefits, labor andproduct markets regulations) and improving productivity (supply sidepolicies) would have a stronger positive effect on expectations andcurrent spending.
-^
In a major fiscal crisis (high government spending, low tax revenues,very large deficit), a credible deficit reduction program induces lesspessimistic expectations, may actually have a positive net effect oncurrent demand and output.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Can a Budget Deficit Reduction Lead to an
Output Expansion? Ireland in the 1980s
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
rate
increased
in
the
first
case
(more
pessimistic
consumers);
decreased in the second case (more optimistic consumers). –^ Also, positive supply side changes in the second time: productivity increasing,tax breaks for foreign firms.
