Assume individuals consider only the short- run effects of changes in future macro variables when forming expectations of future output and future interest rates. Suppose policymakers announce a reduction in future government spending. Which of the following will occur as a result of this expected government spending reduction?
A) A decrease in the expected future interest rate and no change in expected future output.
B) A decrease in the expected future interest rate and an increase in expected future output.
C) A decrease in the expected future interest rate and a decrease in expected future output.
D) A decrease in the expected future interest rate and an ambiguous effect on expected future output.
E) A decrease in the expected future interest rate and a constant expected future output.

Question

Quizplus · Accepted Answer

Individuals consider only short-run effects of changes in future macro variables when forming expectations of future output and interest rates. Thus, a reduction in future government spending would lead individuals to expect a decrease in future output due to lower government expenditure. This expectation of lower output would lead to a decrease in demand for credit and investment, thus lowering the expected future interest rate. Therefore, the expected future interest rate would decrease and the expected future output would also decrease.

Assume Individuals Consider Only the Short- Run Effects of Changes