Author Question: Explain how expectations affect consumption. What will be an ideal ... (Read 45 times)

ereecah · **on:** Jun 30, 2018

Explain how expectations affect consumption.

What will be an ideal response?

Question 2

Based on your understanding of the IS-LM model, graphically illustrate and explain what effect a monetary expansion will have on output, the interest rate, and investment.

What will be an ideal response?

soda0602 · **Reply #1 on:** Jun 30, 2018

Answer to Question 1

Expectations affect consumption in two ways. First, expectations affect consumption directly through human wealth: To compute their human wealth, consumers have to form their own expectations about future labor income, real interest rates, and taxes. Second, expectations affect consumption indirectly, through nonhuman wealth-stocks, bonds and housing: The prices of these assets depend on expectations of future cash flows and interest rates.

Answer to Question 2

An increase in M will cause the LM curve to shift down and the interest rate to fall. As the interest rate falls, firms will increase investment causing an increase in demand and subsequent increase in output. So, the interest rate will fall and Y will rise. I will be higher due to the rise in Y and drop in the interest rate.