L5-6: IS-MP Model Flashcards

Introduction to the IS-MP Model

• What it's about: Imagine the economy as two big markets: one where people buy and sell stuff (goods/services), and another where banks lend money (money market). The IS-MP model helps us understand how these markets work together to shape the economy.

• Key concept: It shows how income (GDP) and interest rates are determined together. It's not just one affecting the other; they dance together.

• Importance: Knowing this dance is crucial! It helps us see if the economy is stable and predict if things might go boom (inflation) or bust (recession).

• Goal: We want a stable dance! This means avoiding those booms and busts.

• Policy Focus: The government (with its spending and taxes – that's fiscal policy) and the central bank (with its control over interest rates – that's monetary policy) try to keep the dance smooth. They want to control how much people spend (aggregate demand) and how much stuff is made (output) to avoid big disruptions.

The Goods Market (Real Sector) AKA, the "Stuff" Market

• Main Idea:

  • Think of prices as being a bit sticky, like trying to pull apart two pieces of gum. They don't change instantly. (That's the Keynesian idea, good for short-term thinking).

  • The market is happy when what people want to buy (aggregate demand or AD) is equal to what's being made (aggregate supply or AS – which is also the same as income, Y). In Lehman's terms, it's all about "what people want equaling what's available."

  • We show this with the IS curve. It slopes downward because if people are earning more (higher income), interest rates need to be lower to encourage them to spend that extra cash (instead of saving it all).

• IS Curve Shifters: What makes people want to buy more or less stuff at any given interest rate?

  • Government expenditure (G): If the government spends more (think building roads or bridges), people have more income, and they buy more stuff.

  • Taxes (T): If taxes go up, people have less money to spend, so they buy less stuff.

  • Expectations of future income growth: If people feel good about the future and think they'll be earning more money, they're more likely to splurge now.

The IS Curve Explained

• Graphical Illustration: Imagine a graph with interest rates on one axis and the amount of stuff being made (output, Y) on the other. The IS curve shows how these two things are related.

• Keynesian Multiplier Effect: If interest rates go down, people borrow more money to invest (I) in businesses and buy more stuff (C). This extra spending creates even more income for other people, who then spend more too! It's like a chain reaction.

• IS Curve Shifts: Anything that makes people want to buy more stuff (at a given interest rate) will shift the whole IS curve.

  • Example: If the government spends a lot more money, the IS curve shifts to the right. This means that for any given interest rate, the economy will be producing more stuff.

The Money Market (Financial Sector) AKA, the "Money" Market

• The MP Curve: This is where the central bank comes in. The MP curve shows what they're doing with interest rates.

• Central Bank's Role:

  • They set interest rates! They decide what the "price of money" is, based on what's happening in the economy (like how fast prices are rising – inflation – or how much stuff is being made).

  • They use tools (like short-term interest rates) to try and guide the economy. Some even follow rules (like the Taylor rule) to decide how to adjust rates.

• Lower Interest Rates:

  • If the central bank lowers interest rates, it's like they're saying, "Let's get this economy moving!" This is shown as a rightward shift of the MP curve. It's a sign they want to stimulate economic activity.

MP Curve Details

• Central Bank's Desired Interest Rate (r): Think of the central bank having a "sweet spot" for interest rates at different levels of income (Y).

• Money Supply Manipulation: The central bank controls how much money is floating around in the economy (M). They do this by buying or selling government bonds. This helps them hit their interest rate target.

• Central Bank's Reaction to Economic Conditions:

  • If the economy is booming, the central bank might raise interest rates. Why? To prevent things from getting too hot (inflation!). Lehman would call this preventing "irrational exuberance" – stopping people from getting too crazy with their spending and investments.

IS-MP Together: Achieving Macroeconomic Equilibrium AKA, Economic Harmony

• Overall Equilibrium: The economy is in balance when both the stuff market (IS curve) and the money market (MP curve) are happy. This happens where the two curves cross on a graph.

• Equilibrium Levels: Where the curves cross tells us the magic number for income (Y) and interest rates (r). That's the happy place for the economy!

• Policy Impact: If the government changes its spending or taxes (fiscal policy) or the central bank changes interest rates (monetary policy), these curves will shift! This means the happy place will move too. Lehman would say this is where "Main Street" (real economy) meets "Wall Street" (finance).

Fiscal Expansion: The Government's Role AKA, Spending Money to Make Money

• Definition: The government decides to spend more money (G goes up). This can lead to an increase in aggregate demand, boosting economic activity as more funds flow into businesses and households.

• Impact: The IS curve shifts to the right! This leads to higher income (Y) and higher interest rates (r).

• Multiplier Effect: The extra government spending creates a ripple effect, boosting the whole economy. This effect amplifies the initial increase in output, as businesses respond by investing more, leading to increased employment and further consumption.

• Central Bank Reaction: BUT the central bank may respond by adjusting monetary policy, potentially increasing interest rates to counteract inflationary pressures that arise from the rising income. As a result, this creates a balancing act between stimulating growth and controlling inflation, which requires careful monitoring of economic indicators.