Question

1. What role do expectations play in the IS curve that underpins the 3- equation model? Provide an example of a situation where a change in expectations of
the future can influence households’ behaviour in the current period and
shift the IS curve.

Answer 1

We know that the role of expectation plays a vital role in economic activity. It intervenes the spending behavior of the people. The Tobin's Q theory is the best example of institutional mechanism like the stock market- talking about the expectation of future investment. Suppose the Q ratio is greater than one then there is a positive investment. The optimistic expectation of the future investment will shift the IS curve to the right. According to the permanent income hypothesis, the current consumption decision will affect the expected future income.