Lecture 24: IS-LM and Expectations
MIT OpenCourseWare・2 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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