expectations play a huge role in
economics so what I want to today not
only in asset pricing I mean asset
pricing obviously it's all about the
future really H but but also in the kind
of issues we have discussed ER in
throughout the course and so that's what
I want to do essentially is I want to uh
give you a shortcut to think about the
role of expectations in in the kind of
models we have already discussed and so
I'm going to do all that in the most
basic mode we have discussed which is
the eslm mod and and and I hope you
you'll get sort of the yeast of what
expectations can do in in economics so
this is going to be a very compressed
version
adapted version of chapters 15 and 16
but in terms of material mapping into
the book those are the relevant chapters
and the main idea here is that the islm
model as we have described it up to now
really it overweights h the present okay
and uh and in practice expectations
about future conditions play a big role
in the decision of all economic actors
we we look at you know investors as a
pricing and so on but it's also true of
consumers it's also true of firms I mean
if you think about firms an investment
decision we made a function of the
interest rate and current output but
it's quite clear that the reason firms
invest is not because of the current
condition it's because they anticipate
making profits in the future so it's all
about fre expectations and even
governments and foreigners when they
invest sort of do foreign direct
investment they go and invest in a
country is a lot about expectations of
what the country will do H in in the
future I mean political elections for
example have huge impact on asset prices
and so on precisely because they change
what people think for good or for bad
about future conditions okay so so
expectations is just huge in economics
so I want to do things in two steps the
first I'm going to revisit sort of the
the consumption function and the
investment function now taking into
account expectations and and motivate
how how you should really think about
consumption an investment in a more
realistic mod than we have been dis
discussing H and then I want to embed
not the fully flesh out consumption and
investment decisions but the flavor of
of the role of the future into H the
islm model okay and uh and by then sort
of you you would have seen you will have
seen all that I wanted to communicate at
least in in in this set of
lectures so let's think about first
consumption um and
uh up to now we assume that consumption
depended only on disposable income you
know on current disposable income um but
that's not the the way it works and one
of the first in
formulating ER more or less formally how
consumption decisions are really made is
Milton fitman and he call it the
permanent income theory of consumption
meaning what really matters to you in a
consumption decision is not so much at
your current income but it's what you
expect to get on average during your
lifetime and and you know you don't want
to be moving consumption up and down
like
crazy you know once you realize sort of
more or less what you'll get on average
then you should consumption should be
related to that
concept and and in a sense it's
also by thinking in this in these terms
you're also drawing a big distinction
between things that are temporary and
that shouldn't matter a lot for your
consumption decisions versus things that
are permanent that clearly have a
potential to have a much larger impact
on your consumption of course you can
have temporary things that are very
large I mean you win the lottery that's
a huge temporary shock but probably
you're not going to spend the whole
Lottery right away you're going to
smooth it over your lifetime in any
event okay and and that actually relates
to more or less at the same time Milton
fredman was at
Chicago Franco modani at MIT
we will develop sort of the life cycle
theory of consumption who says look even
at the level of an
individual the day-to-day income is not
really what pins down the level of
consumption because people know early on
life that they have a lower income than
they will have later on so they will
tend to spend and borrow more when
they're young then in the middle when
they're in the middle of their life
cycle you know before retirement they
panic and you tend to save more so you
don't consume all you have because you
know that there are many years ahead of
you where income will be lower than your
consumption needs so there's also a
sense of inter temporary smoothing of
your consumption you don't follow income
second by second you sort of try to
stabilize consumption over time more or
less and that means that you know you
have to think more about your permanent
income but you'll get on average rather
than what you get in the short ter so
when you start thinking about
consumption in those terms what really
you think well what really matters then
is is total wealth more than income okay
how wealthy you are will pin down more
or less the consumption you have more
than than your current income and there
are two senses of
wealth one is financial wealth okay all
the assets you may have you may expect
to inherit or whatever minus the debts
you have so very much as we discussed in
the previous lecture in the context of
asset pricing the expected present
discounted value of the cash flows of
all the assets you have okay that's your
financial
wealth uh and that's important you have
more financial wealth even if you have
no income today you will probably borrow
against that wealth to the extent that
you can and ER and probably the banks
will be more willing to lend to you if
they know that you have a lot of wealth
H and and so you're going to fund the
consumption which is above your current
income just because you have more
financial wealth
okay in fact the very rich seldom sell
assets they borrow against those assets
to fund consumption that's the that's
the way sort of it works there are tax
advantages of doing that and so on but
but that's the way it works and the very
rich often have no
income at least labor income all the
income comes from from Returns on assets
and uh and again we mostly
borrow but
inent the point there is that what
really pins out your consumption is your
wealth not not the current flow of
income and the other very important
concept which is a bigger thing for most
individuals is human wealth I mean this
is huge for all of you
here it's obvious that your current
income is a lot lower than what your
income will be in the future you have a
lot of human capital okay and and so
that's also concept of expected present
discounted value is you expect to end a
lot of income in the future and
therefore it makes sense that this stage
of your life you borrow now now banks
are a little bit more reluctant of
lending you against your human capital
than lending you against your financial
assets it's easier to borrow against a
house than against your future income
but even there probably you're going to
sort of not going to be saving a lot on
this time of your
life because you know that your income
is a lot higher in the future that's
that we call human wealth okay and total
wealth is just a sum of financial wealth
plus human wealth so at its most basic
level and those are sorry just to relate
to things we did in the previous two
lectures those are two expected present
discounted value you don't know exactly
how much income you're going to get you
get a sense of more or less what
somebody like you does in the future
more or less on average and so on so you
have a sense you have an expected cash
flow labor income flow in the future you
don't know what the interest rates are
exactly so you're going to guess more or
less what the the future interest rate
is and that gives you a sense of human
wealth and I know that many of these
things you're not calculating every what
your human wealth is and then calculate
in general consumes 5% of that or 3.5%
of that but you know a lot of this is
very Behavior it's really ingraining you
and and and uh and uh you're probably
more likely to spend more if you think
that you're going to be doing well in
the future but not maybe you're too busy
now to spend a lot but you know at some
point when you're given the
opportunity that that will make a
difference Traders very successful
Traders they get a very low income so
essentially they live out of the income
that they
get they couldn't afford what they
normally afford but they spend a lot
more than that income because they
expect to get a big bonus and things
like that that's income that comes in
the
future so in principle your consumption
should be something that is not
proportional to your disposable income
but really proportional to your wealth
okay and there are estimates of what
that that proportionality factor is and
that's I said it depends on the type of
assets we're talking about that is about
03 that kind of thing okay
now in reality that's just it's true
this is a better economic concept than
just putting income in there but in
reality both things really matter so a
more realistic consumption function is
something that depends on both things
for a variety of
reasons that maybe we have no savings
and really we call even them hand to
mouth they leave by the income they're
receiv receiving in every single period
those those people are not thinking
about smoothing consumption over time
they're consuming whatever income they
receive ER as I said before most banks
are not likely to lend you a lot against
your expected present discounted value
of Labor income okay so you may be
constrained in the short your your
income you you think about how wealthy
you'll be but you also think about sort
of your flows the cash flow you're
receiving that's also part of of your
consideration so in reality it's a
mixture of those two things when you
look at the micro level at different
individuals the composition changes the
Richer you are the more this term
matters the less this one matters the
poorer you are you know this term
overwhelms that term that's more or less
how it works but on
average it looks like that so you know
we weren't wrong when we did islm and
having the consumption function as
increasing in in in in disposable income
but I always told you there is a lot of
interesting stuff hidden in that little
CZ in the you know in that autonomous
component of consumption well that lots
of interesting things has a lot to do
with wealth
okay and again this term here is
something that captures a lot s of
things that are permanent well this one
captures a lot cyclical components and
things of that kind
so interpreted this way you know the
reason people during
booms even though human wealth may not
change much over time Financial wealth
typically change in in a boom but it's
also the case and in a boom you know
wages are higher and all that and people
tend to spend more okay even so this
captures a lot the temporary component
when you're in a in a boom you're going
to like it's likely that you're going to
consume more for any given level of
wealth okay
it's temporary but that's what it
is what about
investment that's a decision by The Firm
how much physical capital I'm talking
about physical investment real
investment not Financial
investment the decision also depend on
current but particularly on expected
profits and when you think about
expected profits you need to think about
interest rate as well we put the
interest rate aside we say okay it's
more expensive to borrow if the interest
rate is high true but matters a lot more
than just that because it matters also
through the the the the expected present
discounted value of your future cash
flows the interests are very high and
they're expect to remain very high that
means a project that gives you lots of
return in the future lots of cash flow
in the future may not be worth a lot
simply because interest rates are very
high so the discounting of the future
cash flows is very high in that
environment you know Investments that
give you return a quick return are worth
more than things that give have a pay
off very in the very long
run so so the decision for example of
buying a
machine needs to look at the price of
the machine right now and then
unexpected present discounted value of
the cash flows okay so let's think a bit
more carefully about about that decision
H so suppose you buy a machine for a
price let's normalize that price to one
the first thing you need to know is well
how long will this machine last because
I need to know you know for how many
years I'm going to get a cash flow out
of these things h and a reasonable
assumption is is is for most machines
it's have some sort of geometric
depreciation so meaning you know it's
not deterministic it's more or less
machines break break break down
occasionally but there's certain
probability that they break down we
typically call that notation in
economics is we we refer to that as
Delta that's the depreciation
probability so if you think in terms of
expected value you buy a machine today
and you
ask how much of a machine I'll have next
year well it's going to be a weighted
average of zero and one probably but on
average it's going to be one minus Delta
so it's a machine that Peres sort of the
probability of the machine breaking down
over a year is 5% then one minus Delta
is
095 what is the probability that machine
is still producing two years from now
well 1 minus Delta square and so on and
so forth okay so that's the first thing
you know I have this machine and it's
likely to give me cash flows over these
many years and so on and then I have to
know how much I expected profits I
expect to get in each of those years and
then I need also to know what are the
interest rates that are likely to
Prevail during the lifetime of the
machine and so on so at the end of the
day when I calculate I do my little
project and I need to decide whether one
which was the price of the machine or
not is too expensive or too cheap I need
to compare it with the spec present
discounted
value that I have for that machine so
here is an example this is a machine
that gives the first expected cash flow
comes next year I set it up today and I
generate profit by the end of the the
year or at the beginning of the next
year thus expected profits for the first
year of the machine which comes at the
end of the first year is counted by an
interest rate that I know today I know
the interest rate for for one
year what about the cash flow that I
expect for two years from now well
that's going to be that's expected cash
flow if the M machine is working
properly that's the probability that the
machine last to the second year and and
uh or or you can also assume that the
machine sort of breaks down in little
pieces every year you get 90 0 95 of the
machine in second
year 1 minus
1.05 uh Square two years from now and so
on so forth
so but I also now when I think about the
cash flow in the second year I don't
know the interest rate for the second
year so h i I need to have an expected
interest rate
here and so on so forth okay because the
machine lasts for many many years that's
what I get a question by the
way I'm saying yeah I need to have
expectations here and so on
but the truth is that the guy that
invests in the machine doesn't need to
have that expectation because I could
replace this for something that is known
today what would that
be I'm saying you know when I calculate
the expected cash flow when I'm
discounting the two years out cash flow
I'm going to have an interest rate that
I know the one from Time Zero to to the
end of the first year but I don't know
the interest rate that prevails H
from the end of year one to the end of
year two that's what I wrote here but I
said but there is something in the
market that I could look at and that I
really know what is
that exactly I could use one plus R2
these are onee rates
r2t Square
okay so so when you have the ter
structure when you see all the interest
rates a a a firm deciding where invest
on not has the interest it needs it
doesn't need to have expectations form
expectations about the interest rate the
market is doing it for them now the guy
may choose to be a Trader and decide
that I doesn't like the interest rate
that the market is is is pricing in but
that's a different trade it's not the
investment decision of the firm The Firm
will have to make a forecast about
expected cash flow and so on but that's
it from the machine so on
okay so obviously the larger disase the
more you're going to invest the more
machines you're going to buy and so on
okay
um so so in principle you know a better
investment function we remember we wrote
an investment function as investment a
function of output current output which
is said is approxim for sales and then
the interest rate well a better concept
is that one which does depend on
aggregate activity depends on many
things but not only today also the ones
you expect for the future okay and it
depends on the interest rate not only
today's interest rate though also the
interest rate of the
future if I if I look at this expression
you know if if even if the interest rate
today doesn't change but I expect the
interest rate to change in the future to
go up that will lower the value of my
project okay we have had no space for
that when we posit the initial
investment function but but here we have
that and sorry and this is an increasing
function of that the higher is
V the highest expected per discounted
value of buying a machine given the
price the larger is investment now this
is in principle in practice current cash
flows also matter a lot okay H so in the
same sense as in the case of of the
consumption function we said yeah in
principle it's only wealth that matters
but in practice there's lots of
consumers that are financially
constrained they're have to mouth and so
on so current income also matters but
for firms the same is
true
because and and and the main the main
reason for that really is Financial
frictions in the case of the firm
because a firm may arrive with a great
project to a bank but the bank may
decide that it doesn't trust as much
it's or is not as optimistic as the firm
is and so on so it may not
borrow the firm may not be able to
borrow as much as it would want given
how optimistic that particular firm is
you on its own project I may say no you
know I'm going to be more conservative
here since I'm lending you the money and
one way that firms use actually to get
around Financial constraints is simply
by
returning retaining their retaining
earnings meaning they they generate a
cash flow they save firms Save A Lot by
the
way you know companies like apple and so
on save an enormous amount and huge
deposits us treasuries and so on so
forth in the case of Apple is not to
relax Financial constraint although it
is has something to do with being
opportunistic ER having the opportunity
to buy things that are in distress but
many firms especially smaller firms have
deposits and cash flow and so on mostly
because uh if they get a good
opportunity they they may face Financial
constraint so if current activity is
high sales are high firms are going to
be less likely to be financially
constrained and that's the reason
current profits also
end now current profit is going to be an
increasing function of output over over
Capital that you
know for any given level of capital if
output goes up that's going to generate
more profit and so we can write our in
mment function a little bit like we had
in the in in in in the earlier lectures
but now we put VT here why YT and the
interest rate and interest interest and
future output and future interest rates
enter all through the ter here and again
investment here is increasing with
respect to VT and it's increasing with
respect to YT okay so that's a far more
realistic model so you go back
tolm and and and uh and put this type of
consumption function and investment
functions and they're going to make a
lot of
sense again the concept of something
persistent persistent things should
matter a lot more than temporary things
okay so naturally if if you expect
profits to remain high for a very long
period of time that machine is going to
be worth a a lot more than if you only
expect the machine to be very profitable
for only one year okay and and and and
and and so anything that's likely to be
perceived system is also likely to have
a much larger
impact there are important exceptions
but I'm not going to get into that now
and the same is true for interest rates
know if I expect if interest rat are
high today but we expect them to go down
in the near future then that's not going
to affect a lot the discounting of very
future profits but if I if I interest
rate go up today and I expect them to
remain high for a long time that's going
to affect a lot more the present value
of profits and therefore it's going to
depress investment a lot more in
fact central
banks much more than playing with the
current interest rate they play with
your minds that's what they do they they
are always telling you stories for why
interest will remain high for why you
know they don't want they want they only
control an interest rate that is is an
overnight interest rate really but they
and with that nobody cares about the
overnight rate except for some Traders
out there no but since they want to
influence aggregate demand that is they
want to influence consumption and
investment they need to convince you
that this stuff will last for some time
because otherwise it would be relevant
because if you want to reduce aggregate
demand you want to cons
convince firms and households and so on
that that the interest will remain high
for a while otherwise you're going to
get very little effect out of
that one of the pro problem s they're
having now actually you know with the
FED is trying to cool the economy is
that they keep hiking rates but the loan
rates have began to decline already
that's a problem you know they would
like you not to believe Market not to
believe that that will happen and that's
that's a that's a big
issue okay so let's think about this
islm with expectations so what we said
is you know what really we after in the
slm model remember slm model is a model
in which aggregate demand determines
output and that's what happens in the
short and the biggest components of
aggregate demand as aside from the
government which is something that moves
more or less okay different behavioral
functions we're not talking a lot about
that here but the big drivers are
consumption and investment those are at
least the private sector drivers of
aggregate demand consumption and
investment and we have said now is that
you know that H human wealth is affected
not only by current income but future
after future after Labor income future
real interest rate that affects human
wealth that affects
consumption future real dividends plus
future real interest rate affect the
value of stocks that's a very important
Financial well H future nominal interest
rate affect the price of bonds so all
these rates enter here the the price of
nominal
bonds ER for firms future after tax
profits affect expected present value
future real interest rate affect H also
this expected present value okay so
there's a lot that says future in this
column here that enters into the
consumption and investment decisions
that we care about that's what I show
you in in the previous
slides so remember the basic islm model
we wrote it this way output was
determined by agre demand and close
economy forget all that
fully sticky prices and uh and we wrote
consumption as this functions so
aggregate demand was increasing in
output and government expenditure
decreasing in taxes and decreasing on
the interest
rate so a shortcut so what I want to do
now is is give you a shortcut to
integrate this views of expectations or
the concept of expectations into this
very basic isnm model Okay so think of
now of aggregate demand rather than just
being a function of current variables be
also function of the same variables but
in the
future okay so aggregate demand is a
function as before of current output
current taxes current interest rate
current expenditure but also function
and with the same signs of future output
so it's increasing a is increasing in
expected future out output is decreasing
unexpected future taxes is decreasing in
expected future interest rate is
increasing in expected future government
expenditure although I'm not going to
play with this here because of something
very specific I'll discuss later on okay
but so that's the shortcut okay the limb
is going to be the same as before so
what I want you to think about now is a
mod that is like the one you had before
H with the same LM but now that yes is a
little bit richer it has more parameters
these are parameters because I'm going
to determine today's output uh but it's
going to be a function of more
parameters and all these parameters are
essentially the same variables that we
worry about today but are the variables
we
expect of those are the values we expect
for those variables in the future and
again with the same sign so if output so
if taxes go up
today aggregate demand will Decline and
output will decline but if I expect
future taxes to go up as well then
that's going to the price aggregate
demand even more okay that's the type of
logic I want you to devel so that's the
way our model will look so this is the
the is in the same space I had before
know interest rate and a output current
output I'm trying to determine current
output um but now I have lots of
parameters that I didn't have before
I have a you know things that shift the
yes to the left if taxes go up today
this will shift to the left do you think
it will shift to the left more or less
than it did in lecture three or
four so suppose we increase taxes by you
know 10% will that reduce output more or
less than when we have the static islm
mode yeah the expectation okay I haven't
moved these are parameters for my curve
so I I don't get the right to move
them less no less because now we said
it's not only the present that matter
it's a combination of the present and
the future so if if if I that means that
anything that is just the present will
matter less than in the in the past
otherwise you see that and suppose we
had a two period model and and I give
equal weight to the present and the and
the and the and the future then I'm
going to cut the effect of the present
in half that's I'm exaggerating there
that's more or less the logic
okay
um
so so the you you correctly said well it
depends on whether I expect the future
taxes to change or not fine that tells
you there a difference between changing
temporarily the taxes and
and and and and and increasing taxes
permanently permanently here means for
the two periods so what happens with
this curve so we decided that increasing
increasing taxes reduces this to the
left by a smaller amount than in the
past what happens if you expect taxes to
increase in the
future which wealth goes
down human wealth in particular your
human wealth will go down because you
expect your disos able income to be
taxed more in the future so that will
also shift the yes to the to the left
okay and that's the reason that if you
have a permanent expected permanent
increase in taxes today and next year
then that gets us back to the type of
shift in the yes that we had when we had
the static model okay it's the sum of
the two it's a permanent so permanent
changes will behave very similarly to
the way sort of the the the static model
work permanent
okay in a sense that model was a very
good summary of permanent changes
permanent changes in taxes permanent
changes in interest rate and so
on ER changing go on expenditure same
same idea it will also move aggregate
demand to the right
um
but will it do it by more or
less well think how government
expenditure worked in in in the basic
mod in the static model it increased
aggregate demand and that then led to
multiplier and we got a lot more income
and so on now if we expect this govern
to be temporary that multiplier also
will be a lot smaller because yes it
will increase income but people are not
going to spend all day income today that
depends on whether they expect future
income to also go up as well or not okay
and that's the reason that it is again
it us expect this going expenditure to
go up permanently and nothing else
change then you can expect income to go
up in the future as well and then you
get more or less the same effect now
that's a trick experiment because if you
and it's very Rel for today if you
govern exp goes out permanently it's
unlikely that the central bank will
remain and and move and so you also have
to start thinking well where will the
Central Bank do okay and that takes me
to this variable here okay this variable
here
so well before I discuss this variable
actually let me point out that it's not
accidental that I made this curve a lot
steeper than it used to look I mean this
looks like a pretty steep I curve which
is a way of saying that a given change
in interest rate now has a very small
effect on current
output okay much smaller than we have in
the static
model and the reason is
again this permanent investor transitory
if you expect the interest rate to
decline only for today and that's it
that's not going to have a very large
effect on consumption it's not going to
have a very large effect on on on
investment for the interest rate de
client to have a very lasting effect a
very large impact on consumption and
investment it has to affect the expected
present discounted values in a
meaningful way and for that you want
those changes to be more or less
permanent persistent that you
the private agents think that this
change in the interet will
be significant so so if they if so it
good to separate two things so if the if
the if the if the FED cuts the interest
rate but doesn't persuade anyone that
that that this rate will remain low in
the future then it will is going to get
very small effect on out however if you
convince people that that there will be
future changes that the the rates will
remain lower for a long time that means
that this is now will shift to the right
okay that's what we have
here so you have to distinguish is a
move when the FED cuts the interest rate
you get a small movement along the curve
but if the fed persuades you that this a
long lasting cut in interest rate then
they yes shift to the right and you
recover sort of the power of monetary
policy monetary policy depends a lot on
its ability to convince people that
things will remain in the direction this
they want okay if they fail there was a
famous episode in US monetary policy
during the times of Alan greensman Alan
gensman is known as one of the biggest
Central Bankers that the US has had at
least in recent
memory H he went through a period which
was called was known as the Greenspan
conu that is the economy was
overheating he kept hiking interest
rates but the long rates kept coming
coming down so he couldn't cool off the
economy there was no way around that
because they couldn't persuade the
markets that that this would be a longl
lasting effect the reason was a
different one it was not that you
couldn't persuade the market it happens
that at the same time you had china
sending massive Capital flows to the US
and so so but the point is that the FED
had couldn't move the interest rate in
the long run and and so it was very
ineffective in terms of his monetary
policy so again expectations matter
quite a
bit so let's think about our well this I
was just discussing so monetary policy
you know I should have this so you're
not going to do a lot if if unless you
persuade people that that the interest a
will remain low for quite some time and
notice that there like here this
everything comes comes into line because
if the FED convinced that the interest
rate will be lower in the future as well
then you get the yes to shift to the
right but if inter will be low in the
future that means output will be high in
the future as well which further shift
that yes to the right okay if you
convince the markets that and the
markets and cons consumers households
and so on that that you're cutting
interest rate and that with that you'll
be successful in creating a getting out
of a recession for example in the future
that also increases human wealth
expected percent value of cash flows of
of profits and so on so forth because
you you giving sort of better economic
conditions in the future again for
central banks is a lot like er it's it's
mostly about expectations management
that's the business of a central bank
really I don't know how many of you are
soccer fans but but um there was a
famous story of Marvin King Marvin King
was also one of the biggest Central
Bankers that the UK has had fairly
recent and he described he's British L
nowadays and he described um good
monetary policy very much like
maradona's go score against the
UK England in in in in in some World cap
I don't remember which
one and it's essentially Maradona picked
the ball you know in his side of the
field and he essentially RW a straight
line H to the goal and a score but but
he persu Ed everyone around to move away
from his path and that was a successful
strategy and central banks do a lot of
that lots of talking and you know at the
end of the day the true actions of
moving the interest rate are the least
important part of really the a monetary
policy
strategy fiscal policy can be quite
tricky here actually
um so we know that that you know that
the fiscal
contraction a reduction in government
expenditure ER if you just think about
the basic islm model what happens it's a
fiscal contraction you reduce go in
expenditure that will
certainly reduce
output all the slm you reduce govern
expenditure just shift the to the left
and that reduces
output when you have expectations things
are a little
trickier because it depends a lot of
what you expect the central bank to do
in the future
and it expects a lot on what you
know the private sector how the private
sector responds to that so for example
if you have a a um fiscal contraction
that leads to an anticipation of a big
cutting interest rate in the future that
may be expansionary or is it can ofset
quite a bit of the fiscal contraction
side and in fact most of the time when
you have episodes of fiscal consolid
solation H in environments that are not
of very high distress financial crisis
and so on H it typically sort of how
successful that is depends a lot on
whether people expect to be a sort of
implicit deal between the central bank
and the treasury okay if people expect
that that fiscal contraction will come
with much looser monetary policy
conditions then the fiscal contraction
is
not as contraction as could be otherwise
and if for some reason you know know the
fiscal deficit sort of the perception of
fiscal deficit was really dragging the
economy down because people didn't know
when there could be a financial crisis
in the near future and so on then you
can get a situation in which the
contraction fiscal contraction today
improves the perception of a stability
of the country in the future which in
turn may increase expected future income
and and and be expansionary
so you know most of the fiscal
contractions are contractionary but
there are some famous
of what they of called expansionary
fiscal
contractions one of the most classic
cases was known case is
Ireland in the late 80s Ireland had
massive fiscal deficit and and and all
they talk about was fiscal deficits okay
because they had very large fiscal
deficits related to GDP and and the
economy was really sort of stagnating
and going through cycles and so on and
it was all around this fiscal deficit
and so so towards the late 80s they
began a a deliberate plan
of of U of fiscal consolidation fiscal
consolidation means essentially reducing
the deficit and they were very
successful as you can see but contrary
to expectations at least output growth
did not declin actually they finally
sort of they had a very good period like
that so that's that's all it was all
about expectations notice that
unemployment though did go up okay so
despite the fact that you know you got
more unemployment and so on output began
to grow okay because firms began to
invest more consumers became more
optimistic in fact you see the house
household saving rate declined
dramatically this all consumption and
investment did that
okay consumption and investment people
consume more invested more because sort
of everything looks a lot better they
have been struggling with this for very
long and they finally they had gotten
that
behind now this example is Abus by
almost anyone that wants to cut taxes
and things like that but
but
um um no sorry by almost anyone that
wants to cut fiscal expenditure um but
there are experiences there's a whole
spectrum of experiences but in
situations that as Extreme as this
one it it clearly prove to be very
effective so that's that so let me take
a stock so so the role of this lecture
was ER to say something that I sort of
should have said earlier on but I would
have been a bit confusing so I decided
not to talk too much about it but it's
very important expectations plays play a
central role in economic
in particular H expectations influence
aggregate demand and for us this course
was a lot about aggregate demand except
for the part on growth it was a lot
about agre demand now we did talk about
expectations but we did talk about
expectations mostly in the context of
agre Supply remember when we talk about
the Philips curve we did have
expectations because weight setting was
a function of expected prices and so on
so forth so we did talk about the role
of expectation Supply very quickly uh
but I think a much bigger role is play
of expectation is really on on aggregate
demand and certainly on asset prices but
aggregate demand asset prices are
connected because agre asset pric is
about wealth and you know and and the
value of future cash flows which are
more or less the same drivers as for
investment and and and and consumption
and finally I want to say the many times
when you find sort of episodes of
fiscally even sometimes monetary policy
that are
counterintuitive is entirely due to the
the expectations part so this case of
fiscal consolation is not that the C the
cutting in fiscal
expenditure was expansionary that was
not that was contractionary but it was
overwhelmed or offset more than upset by
the out the Improvement in the
Outlook that that uh that you had and
that also happens with monetary policy
countries that have high inflation
problems and so on er er
sometimes ER get and they have to go
through dramatic tightenings and so on
yes most of them get sort of very short
lead recession but sometimes they're
very short lead recessions because
eventually sort of the the the reduction
of the in the instability caused by by
high and unstable inflation sort of ends
up dominating any direct contractional
effect of monetary
a e