IS/MP model

The IS/MP model (Investment—Saving / Monetary—Policy) is a macroeconomic tool which displays short-run fluctuations in the interest rate, inflation and output

Formation

The IS and MP curves are distinct curves, utilized by "mapping" movements of one curve onto the other.

MP Curve

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, where the real interest rate is located the horizontal axis and inflation on the vertical axis. The Taylor Rule plays a role in the formulation of the MP curve: when inflation rises one percent the central bank should raise the nominal interest rate by more than one percentage point.

Shifts on the MP curve are produced by actions of the Federal Reserve. So, a target decrease in the federal funds rate, ${\overline {i}}$, shifts 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

IS Curve, where Q represents output

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.

Diagrammatically, the IS curve displays a negative relationship between the real interest rate, located on the vertical axis, and total output, on the horizontal axis.

Shifts on the IS curve are produced by actions of the government and consumers. For example, an increase in either consumer or government spending shifts the IS curve right, resulting in an increase in total output for any level of the interest rate.

Analysis

Example: A lowering of the fund funds target, decrease in ${\overline {i}}$, would shift the MP curve left, resulting in a lower interest rate, and higher inflation. This lower interest rate results in a downward movement along the IS curve, increased output.

Incorporation into larger models

The IS/MP model is used as a foundation for the AD-AS model. When used within the AD-AS framework we may derive long-term movements in inflation and interest rates, rather than base, short-run movements.

Criticism

Harvard Professor Greg Mankiw maintains the IS/MP model has "quirky features". Mankiw prefers the IS/LM model, for, according to him, it focuses on "important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background."