A Simple IS/MP Model

The IS/MP Diagram

The IS Curve

Several Keynesian models incorporate an IS Curve. The expanded discussion covers all these cases.

The MP Curve

The MP Curve shows how the central bank sets the
interest rate in reaction to the level of income **Y**. The idea is
that the central bank leans against the wind, raising **r** when **Y** is
high and lowering **r** when **Y** is low.

The simplest case is a horizontal MP Curve. In
this case, the central bank simply sets the interest rate. The IS Curve
then determines the level of **Y**.

The diagram to the right lists the real interest rate rather than the nominal interest rate on the vertical axis. The distinction does not matter if prices are taken to be fixed. The discussion of the more general version of the IS/MP Model includes a more complete analysis of the model's properties, and the real interest rate is appropriate for that case.

Analysis

The effect of a monetary policy that changes the interest rate is fairly obvious. As the MP curve, which is horizontal, goes up and down, income changes according to the slope of the IS Curve. Fiscal policy, on the other hand, shifts the IS Curve.

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Keynesian Models