Macro Topic E - Expectation

C and expectations

Previously assumed C depends on disposable income (c₀) and MPC (c₁)

Now C depends on total wealth → C_t = C

what makes up total wealth

Total wealth = human wealth + non-human wealth

Human wealth

expected present value of after-tax current and future labour income

• Wealth depends on current taxes / income and how you expect taxes / income to be in the future

Non - human wealth

financial wealth + housing wealth

financial wealth

the value of stocks and bonds + the value of savings

Housing wealth

Value of house - mortgage left

Total wealth theory of C

Individuals smooth shocks to income across their lifetimes

• if they can correctly anticipate the future

C in reality

C reacts to current changes in income

• Individuals incorrectly judge expectations about the future

  • Individuals are financially constrained

How do expectations affect C

Directly - Human wealth & Indirectly - Non-human wealth

• If the consumer decides the decrease in income is permanent / transitory, they are likely to decrease consumption one-for-one / less than 1-1

• Consumption may move even if current income does not change due to changes in consumer confidence

How expectations directly affect C

expectations of future labour income, real interest rates and taxes change

How expectations indirectly affect C

Financial markets & i play a role

I & expectations

I depends on Y + r & Y^e + r^e → Investing in K depends on expected profits and current costs

I depends positively on Y^e & negatively on r^e

AD and expectations

i now affects C

r^e affects Human + non-human wealth + I

Increase in Current and expected future post tax real labour income

increase HW → C increases

Increase in current and expected future real dividends

stock prices UP → increase NHW → C increases

decrease in r & r^e

increase HW → C increases

&

stock prices UP → increase NHW → C increases

&

Present values of real after tax profits UP → I increases

Decrease in i & i^e

Bond prices UP → NHW increase → C increases

Increase in current and expected future real after tax profits

Present values of real after tax profits UP → I increases

IS and expectations

Downwards sloping

Steeper - changes in current r not only determinant of I

Increase in G or Y^e → Shift right

Increase in T, T^e or i^e → shift left

Multiplier under expectations

changes in current r have smaller impact in present

IF they dont change expectations

Expectations and AD-AS

Expectations only affect SR

FP - G decrease - NO EXPECTATIONS

FP - G decrease - EXPECTATIONS

Y = Y^e & T = T^e r & i are different to r^e & i^e

i & r fall → HW + NHW +I rise

AD shifts after initial AD fall

Austerity plans and current effects

Back loading - Expected cuts in G will increase Y in current

• works unless cuts aren’t credible if deficit reduction programme doesn’t look good

• Govt must play balancing act - enough cuts in current to show commitment to deficit reduction + enough cuts left to future to reduce adverse effects on economy in SR.

Negative AS shock - NO EXPECTATIONS

Negative AS shock - EXPECTATIONS

Y^e falls i^e & r^e rise T^e unchanged - exogenous

Y + p + i fall & u rises

Expectations & static vs dynamic model

in MR:

Static → Y i r T unchanged

Dynamic → i affected so i^e changes ∆ g_m = ∆π = ∆i

Expansionary MP + expectation in DYNAMIC MODEL

Expansionary MP →∆g_m increase → i increase → i^e increase → AD shifts inwards

Back loading

Expected cuts in G will increase Y in current