IS/MP model

The IS/MP model (Investment—Saving / Monetary—Policy) is a macroeconomic tool which demonstrates the relationship between interest rates, inflation and output.

Formation

MP Curve

The MP curve is given by the equation

$r=\pi \phi +{\overline {i}}$

where $r$ is the real interest rate, $\pi$ is the inflation rate, ${\overline {i}}$ is the level of federal funds, and $\phi$ is the given parameter.

Diagrammatically, the MP curve displays a positive relationship, upward sloping curve, with the real interest rate on the horizontal axis and inflation on the vertical axis.

Shifts and movements on the MP curve are produced by the action of the Federal Reserve. So, a target decrease in the federal funds rate, ${\overline {i}}$, results in a shift of the MP curve to the left, which results in a decrease in the real interest rate and an increase in the inflation rate.

IS curve

The IS curve is given by the equation

$Y={\frac {1}{1-mpc}}[A-mpc(T)-\alpha r]$

Where $Y$ is output, $mpc$ is the marginal propensity to consume, $A$ is aggregate spending and investment by consumers and government, $T$ represents taxes, $/alpha$ is the given parameter and $r$ is the level of the interest rate.