CH16: Expectations, Output, and Policy

What determines human wealth in consumption decisions?

Expected future after-tax labor income and expected real interest rates

What are the components of total demand in a closed economy?

Consumption , Investment , and Government spending

How do expectations affect the IS curve?

They make the IS curve steeper, reducing the impact of current policy rate changes

How does an increase in r or r^e affect private spending A ?

It decreases private spending

What does the new IS curve equation with expectations look like?

Y=A(t,Y,T,r,W,Y^e,T^e,r^e)+G

What is the shape of the LM curve under rational expectations?

Horizontal at the central bank–set real interest rate

When is monetary policy most effective?

When it shapes expectations of future interest rates and output

What happens if expected rates do NOT change after a rate cut?

Output changes only slightly; investment decisions remain stable

Name three channels through which monetary policy affects the economy

Wealth channel, balance sheet channel (Tobin’s Q), lending channel

What are "rational expectations"?

Forward-looking expectations formed using all available information

What determines the effect of monetary policy on output?

Its impact on expectations

How does deficit reduction affect output under static expectations?

It always reduces output (contractionary effect)

How can deficit reduction lead to increased output under expectations?

If it reduces expected future taxes and government debt.

What is the primary balance?

Government revenue minus government spending, excluding interest payments

What is the condition for reducing debt-to-GDP ratio when r-g<0?

Government debt can fall even with a primary defici

How do expectations influence the success of deficit reduction?

Positive expectations can shift the IS curve right, offsetting contraction

What factors influence the outcome of fiscal consolidation?

Timing, credibility, composition of cuts, monetary policy response, and initial debt levels.