Expectations in Macroeconomics
EXPECTATIONS IN AS - INFLATION
We have already incorporated expectations of the price level into the model. These took 2 forms, adaptive (backwards-looking) and rational (we use our knowledge of the macroeconomy to work out how current decisions will affect prices).
Inflation expectations can be measured in two ways:
1. From surveys of consumers and firms
2. Comparing the yields on nominal bonds with that on real government bonds of the same maturity.
Bonds differ in two basic dimensions:
1. Default risk: the risk that the issuer of the bond will not pay back the full amount promised by the bond.
2. Maturity: the length of time over which the bond promises to make payments to the holder.
Bonds of different maturities each have a price and an associated interest rate called yield to maturity or simply the yield.
The relation between maturity and the yield is called the yield curve. The yield curve tells us what interest rates are expected to be in the future. An upward sloping yield curve means that long-term interest rates are higher than short-term interest rates. Financial markets expect short term rates to be higher in the future. A downward sloping yield curve means that long-term interest rates are lower than short-term interest rates. Financial markets expect short-term rates to be lower in the future.
EXPECTATIONS IN AD - CONSUMPTION
So far we had assumed a very simplistic consumption function (C= c0 + c1*Yd). We now want to include the idea of wealth as a determinant of consumption and therefore expectations will play a role.
A theory of consumption based on wealth was developed by Milton Friedman in the 1950s, called the permanent income theory of consumption, and by Franco Modigliani, who called it the life cycle theory of consumption.
So, consumers decide how much to consume based on the value of their total wealth, which comprises of the value of his human wealth and non-human wealth together.
The value of human wealth is the expected present value of after-tax current and future labour income.
The value of non-human wealth equals the sum of financial wealth and housing wealth. Financial wealth is the value of stocks and bonds, the value of savings. Housing wealth is the value of their houses less the mortgage still due. Wealth overall depends upon price*quantity of these financial assets. And current values (current prices) depend upon the expectations of the future.
The theory of consumptions suggests that individuals will smooth shocks to income across their lifetimes. In reality, consumption reacts to current changes in income. This might be because individuals incorrectly judge expectations about the future.
Expectations affect consumption in two ways:
1. Directly through human wealth, or expectations of future labour income, real interest rates and taxes.
2. Indirectly through non-human wealth - stocks, bonds and housing. Expectations of the value of non-human wealth are computed by financial markets (the interest rate matters).
This dependence of consumption on expectations has two main implications for the relation between consumption and income:
1. If the consumer decides the decrease in income is permanent, they are likely to decreases consumption one for one.
2. If the consumer decides the decrease in income is transitory, they are likely to decreases consumption less than one for one to fluctuations in current income.
3. Consumption may even move if current income does not change (maybe due to changes in consumer confidence).
EXPECTATIONS IN AD - INVESTMENT
Investment decisions depend on current sales, the current real interest rate and on future expectations. The decision to buy a machine depends on the present value of the profits the firm can expect from having this machine versus the cost of buying it. Thus, investment depends positively on Y_e and negatively on r_e.
EXPECTATIONS AND DECISION
Consumption and investment depend on expectations. Further, we assume that the expected inflation and the future expected inflation are both zero. Therefore, nominal and real interest rates are equal. Also for simplification, we reduce the present and the future to only two periods, a current period, which one can think of as the current year and a future period, which one can think of as all future years lumped together. So, now the AD function depends on the current and future value of variables.
Expectations affect consumption and investment decisions, both directly and through asset prices. To model it we make a simplification. Let's reduce the present and the future to only two periods (1) a current period, which you can think of as the current year and (2) a future period, which you can think of as all future years lumped together. This way, we do not have to keep track of expectations about each future year.
Given expectations, a decrease in the real interest rate leads to a small increase in the output: IS curve is steeply downward sloping. Therefore, a large decrease in the current interest rate is likely to have only a small effect on equilibrium income, for two reasons:
1. A decrease in the current real interest rate does not have much effect on spending if future expected rates are not likely to be lower as well
2. The multiplier is likely to be small. If changes in income are not expected to last, they will have a limited effect on consumption and investment.
We have seen that expectations about the future play a major role in spending decisions. This implies that expectations enter the IS relation: private spending depends not only on current output and the current real interest rate but also on expected future output and the expected future real interest rate. In contrast, the decision about how much money to hold is largely myopic: the two variables entering the LM relation are still current income and the current nominal interest rate.
We have already incorporated expectations of the price level into the model. These took 2 forms, adaptive (backwards-looking) and rational (we use our knowledge of the macroeconomy to work out how current decisions will affect prices).
Inflation expectations can be measured in two ways:
1. From surveys of consumers and firms
2. Comparing the yields on nominal bonds with that on real government bonds of the same maturity.
Bonds differ in two basic dimensions:
1. Default risk: the risk that the issuer of the bond will not pay back the full amount promised by the bond.
2. Maturity: the length of time over which the bond promises to make payments to the holder.
Bonds of different maturities each have a price and an associated interest rate called yield to maturity or simply the yield.
The relation between maturity and the yield is called the yield curve. The yield curve tells us what interest rates are expected to be in the future. An upward sloping yield curve means that long-term interest rates are higher than short-term interest rates. Financial markets expect short term rates to be higher in the future. A downward sloping yield curve means that long-term interest rates are lower than short-term interest rates. Financial markets expect short-term rates to be lower in the future.
EXPECTATIONS IN AD - CONSUMPTION
So far we had assumed a very simplistic consumption function (C= c0 + c1*Yd). We now want to include the idea of wealth as a determinant of consumption and therefore expectations will play a role.
A theory of consumption based on wealth was developed by Milton Friedman in the 1950s, called the permanent income theory of consumption, and by Franco Modigliani, who called it the life cycle theory of consumption.
So, consumers decide how much to consume based on the value of their total wealth, which comprises of the value of his human wealth and non-human wealth together.
The value of human wealth is the expected present value of after-tax current and future labour income.
The value of non-human wealth equals the sum of financial wealth and housing wealth. Financial wealth is the value of stocks and bonds, the value of savings. Housing wealth is the value of their houses less the mortgage still due. Wealth overall depends upon price*quantity of these financial assets. And current values (current prices) depend upon the expectations of the future.
The theory of consumptions suggests that individuals will smooth shocks to income across their lifetimes. In reality, consumption reacts to current changes in income. This might be because individuals incorrectly judge expectations about the future.
Expectations affect consumption in two ways:
1. Directly through human wealth, or expectations of future labour income, real interest rates and taxes.
2. Indirectly through non-human wealth - stocks, bonds and housing. Expectations of the value of non-human wealth are computed by financial markets (the interest rate matters).
This dependence of consumption on expectations has two main implications for the relation between consumption and income:
1. If the consumer decides the decrease in income is permanent, they are likely to decreases consumption one for one.
2. If the consumer decides the decrease in income is transitory, they are likely to decreases consumption less than one for one to fluctuations in current income.
3. Consumption may even move if current income does not change (maybe due to changes in consumer confidence).
EXPECTATIONS IN AD - INVESTMENT
Investment decisions depend on current sales, the current real interest rate and on future expectations. The decision to buy a machine depends on the present value of the profits the firm can expect from having this machine versus the cost of buying it. Thus, investment depends positively on Y_e and negatively on r_e.
EXPECTATIONS AND DECISION
1. IS
a. Consumption - Depends on wealth
b. Investment - Depends on expected and current income and interest rates
c. Government Expenditure - Exogenous
d. Taxation - Exogenous
e. Net exports - Equal to zero - Closed economy
f. Exchange rate - Not considered - Closed economy
2. LM
a. Money demand - Choice between money and bonds
b. Money supply - Exogenous, growth rate of money supply is zero in the medium run
3. Production function - One type of output and technological change. Depends on labour only, with constant returns to scale. Labour force is constant.
4. Labout market - Determined by the interaction of wage setting and price setting equations. Expectations of prices are fixed in the short run
5. Technological change - Equal to zero
Consumption and investment depend on expectations. Further, we assume that the expected inflation and the future expected inflation are both zero. Therefore, nominal and real interest rates are equal. Also for simplification, we reduce the present and the future to only two periods, a current period, which one can think of as the current year and a future period, which one can think of as all future years lumped together. So, now the AD function depends on the current and future value of variables.
Given expectations, a decrease in the real interest rate leads to a small increase in the output: IS curve is steeply downward sloping. Therefore, a large decrease in the current interest rate is likely to have only a small effect on equilibrium income, for two reasons:
1. A decrease in the current real interest rate does not have much effect on spending if future expected rates are not likely to be lower as well
2. The multiplier is likely to be small. If changes in income are not expected to last, they will have a limited effect on consumption and investment.
We have seen that expectations about the future play a major role in spending decisions. This implies that expectations enter the IS relation: private spending depends not only on current output and the current real interest rate but also on expected future output and the expected future real interest rate. In contrast, the decision about how much money to hold is largely myopic: the two variables entering the LM relation are still current income and the current nominal interest rate.
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