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Lecture 24: IS-LM and Expectations

MIT OpenCourseWare・32 minutes read

Expectations play a crucial role in economic decision-making, influencing both aggregate demand and asset prices. Fiscal and monetary policies, often driven by future expectations rather than immediate impacts, can have long-term positive effects despite short-term contractionary impacts.

Insights

  • Expectations about future income and wealth significantly impact both consumption and investment decisions in economics, playing a crucial role in determining economic outcomes beyond current conditions.
  • The integration of future variables, such as expected future output, taxes, and interest rates, into economic models like the IS-LM model enriches our understanding of aggregate demand and output determination, showcasing the importance of considering long-term expectations in shaping economic policies and decisions.

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Recent questions

  • How do expectations impact economic decisions?

    Expectations play a crucial role in economic decisions, influencing both consumption and investment choices. Individuals and firms consider not only current conditions but also expectations about future income, profits, and interest rates. Consumption decisions are influenced by expectations of future income, as highlighted by theories like Milton Friedman's permanent income theory and Franco Modigliani's life-cycle theory. Investment decisions are impacted by expected profits and interest rates, affecting the present discounted value of future cash flows. Overall, expectations about future conditions heavily influence economic actors' decisions, emphasizing the importance of considering wealth and future income in economic decision-making.

  • What factors influence investment decisions?

    Investment decisions are influenced by a combination of current conditions and expectations about future profits and interest rates. Firms consider factors such as the price of the investment, its expected lifespan, and the expected present discounted value of future cash flows. High interest rates can devalue future cash flows, making investments with quick returns more favorable. The concept of persistent profits and interest rates significantly influences the value of investments, impacting firms' decisions to invest in physical capital like machines. Financial constraints, current profits, and future expectations of profits and interest rates all play a role in determining the value of investments and influencing aggregate demand.

  • How do fiscal policies impact economic output?

    Fiscal policies, such as changes in government expenditure or taxes, can have significant impacts on economic output. Increasing taxes or reducing government expenditure can shift the IS curve, affecting aggregate demand and output determination. Expectations about future fiscal policies can also influence economic decisions. Fiscal contractions, if they improve future economic stability, can be expansionary despite seeming contractionary in the short term. For example, Ireland's fiscal consolidation in the late '80s led to output growth despite rising unemployment, showcasing the complex interplay between fiscal policies, expectations, and economic outcomes.

  • Why are future cash flows important in investment decisions?

    Future cash flows are crucial in investment decisions as they determine the present value of an investment. When considering purchasing a machine, for example, firms must calculate the expected present discounted value based on expected profits over each year, interest rates, and the machine's longevity. The prevailing interest rates during the machine's lifetime impact the present value of its profits, influencing the decision-making process. Additionally, factors like depreciation probability and the machine's expected lifespan play a role in determining if a machine's price is reasonable, highlighting the significance of future cash flows in investment evaluations.

  • How do expectations influence aggregate demand?

    Expectations play a crucial role in influencing aggregate demand by shaping consumption and investment decisions. Future expectations of profits, interest rates, and output are essential in determining the value of investments and influencing overall economic activity. Integrating future variables into economic models, like the IS-LM model, enriches the understanding of aggregate demand and output determination. Changes in parameters, such as taxes or government expenditure, can shift the IS curve, impacting aggregate demand. Expectations about future monetary and fiscal policies can offset the effects of contractions, showcasing the intricate relationship between expectations, economic decisions, and aggregate demand.

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Summary

00:00

Role of Expectations in Economic Decision-Making

  • Ricardo Caballero emphasizes the significant role of expectations in economics, particularly in asset pricing and various economic decisions.
  • He aims to provide a simplified understanding of the impact of expectations in economic models, focusing on the IS-LM model.
  • The IS-LM model, as discussed, tends to overemphasize the present, while expectations about future conditions heavily influence economic actors' decisions.
  • Consumption decisions are not solely based on current disposable income but are influenced by expectations of future income, as highlighted by Milton Friedman's permanent income theory and Franco Modigliani's life-cycle theory.
  • Consumption is more closely related to total wealth, including financial wealth (assets minus debts) and human wealth (expected future income), rather than just current income.
  • Human wealth, based on expected future income, plays a significant role in determining consumption patterns, with individuals tending to borrow against future income.
  • Investment decisions by firms are not only influenced by current conditions but also by expected profits and interest rates, impacting the expected present discounted value of future cash flows.
  • The decision to invest in physical capital, such as machines, involves considering the price of the machine, its expected lifespan, and the expected present discounted value of future cash flows.
  • High interest rates can devalue future cash flows, making investments with quick returns more favorable than those with longer pay-offs.
  • Overall, both consumption and investment decisions are influenced by a combination of current conditions and expectations about future conditions, highlighting the importance of considering wealth and future income in economic decision-making.

13:59

Machine Depreciation and Investment Decision Factors

  • Depreciation probability is crucial when considering the expected value of a machine purchase, with the machine's value likely to decrease over time.
  • The probability of a machine breaking down over a year, for example, at 5%, affects the expected cash flows over multiple years.
  • Calculating the expected present discounted value is essential when determining if a machine's price is reasonable.
  • Expected profits over each year, interest rates, and machine longevity all play a role in decision-making.
  • The interest rates prevailing during the machine's lifetime impact the present value of the machine's profits.
  • The concept of persistent profits and interest rates significantly influences the machine's worth and investment decisions.
  • Financial constraints can affect a firm's ability to invest, leading to firms saving earnings for future opportunities.
  • Current profits are influenced by output over capital, impacting a firm's investment decisions.
  • Future expectations of profits and interest rates are crucial in determining the value of investments and influencing aggregate demand.
  • Integrating future variables into the IS-LM model, such as expected future output, taxes, and interest rates, enriches the understanding of aggregate demand and output determination.

28:17

Impact of Fiscal Policy on Output Growth

  • The IS curve represents the relationship between interest rates and output.
  • Changes in parameters, like taxes, can shift the IS curve.
  • Increasing taxes by 10% may reduce output less than in a static IS-LM model.
  • Expectations about future taxes can also impact the IS curve.
  • Permanent changes in taxes or government expenditure can mimic the effects of the static model.
  • Fiscal policy, like a reduction in government expenditure, can impact output.
  • Expectations about future monetary policy can offset the effects of fiscal contractions.
  • Fiscal contractions can be expansionary if they improve future economic stability.
  • Ireland's fiscal consolidation in the late '80s led to output growth despite rising unemployment.
  • Expectations play a crucial role in economics, influencing aggregate demand and asset prices.

43:13

Impact of Future Cash Flows on Investments

  • Future cash flows are crucial in understanding wealth and investment decisions, with fiscal and monetary policies often driven by expectations rather than immediate impacts. Fiscal cuts may seem contractionary, but if they improve the economic outlook, they can be offset by the positive expectations. Similarly, high inflation countries may experience short-lived recessions due to monetary tightening, but the long-term stability gained from reducing inflation overshadows the immediate contractionary effects.
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