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Chapter 18
Monetary Theory II: The IS-MP Model
Brief Chapter Summary and Chapter Objectives
18.1 The IS Curve (pages 551–562)
Understand what the IS curve is and how it is derived.
Aggregate expenditure is the sum of consumption, investment, government purchases, and net
exports. Equilibrium occurs in the goods market when aggregate expenditure, or the value of
goods and services demanded, equals the value of goods and services produced, or real GDP.
The Fed’s goal is to have equilibrium GDP close to potential GDP, which is the level of real
GDP attained when all firms are producing at capacity.
The series of induced changes in consumption spending that results from an initial change in
autonomous expenditure is called the multiplier effect. The change in GDP resulting from a
change in autonomous expenditures is called the multiplier.
The IS curve shows the combination of real interest rates and GDP where the goods market is in
equilibrium.
The IS curve can be modified to reflect the relationship between real interest rates and the output
gap.
A demand shock is a change in one of the components of AE that causes the IS curve to shift.
18.2 The MP Curve and the Phillips Curve (pages 562–570)
Explain the significance of the MP curve and the Phillips curve.
According to the IS-MP model, when the Fed changes the real interest rate, the output gap
changes.
The Phillips curve represents the short-run trade-off between inflation and cyclical
unemployment and can shift in response to supply shocks and changes in expectations of the
inflation rate.
Instead of considering the relationship between inflation and cyclical unemployment, we can use
Okun’s Law to derive a Phillips curve that relates the inflation rate to the output gap.
18.3 Equilibrium in the IS-MP Model (pages 570–579)
Use the IS-MP model to illustrate macroeconomic equilibrium.
The Fed typically fights recessions by lowering the federal funds rate so that AE increases,
causing the output gap to return to zero and inflation to return to its previous rate.
During the financial crisis of 2007-2009, long-term real interest rates did not respond as much as
they typically do to the decline in the federal funds rate because of a rise in the risk premium.
18.4 Are Interest Rates All That Matter for Monetary Policy? (pages 579–581)
Discuss alternative channels of monetary policy.
In the bank lending channel, a monetary expansion increases banks’ ability to lend, and
increases in loans to bank-dependent borrowers increase their spending.
In the balance sheet channel, contractionary monetary policy reduces net worth, thereby raising
the cost of external financing by more than the increase that is implied by higher interest rates,
which in turn reduces firms’ ability to invest in plant and equipment.
18A Appendix: The IS-LM Model (pages 588–591)
Use the IS-LM model to illustrate macroeconomic equilibrium.
The IS–LM model differs from the IS-MP model in that it assumes that the Fed is targeting the
money supply rather than the federal funds rate.
Key Terms
Aggregate demand shock A change in one of the
components of aggregate expenditure that causes
the IS curve to shift.
Balance sheet channel A description of how
interest rate changes resulting from monetary
policy affect borrowers’ net worth and spending
decisions.
Bank lending channel A description of how
monetary policy influences the spending
decisions of borrowers who depend on bank loans.
Fiscal policy Changes in federal government
purchases and taxes intended to achieve
macroeconomic policy objectives.
IS curve A curve in the IS–MP model that shows
the combinations of the real interest rate and
aggregate output that represent equilibrium in the
market for goods and services.
IS–MP model A macroeconomic model that
consists of an IS curve, which represents
equilibrium in the goods market; an MP curve,
which represents monetary policy; and a Phillips
curve, which represents the short-run relationship
between the output gap (which is the percentage
difference between actual and potential real
GDP) and the inflation rate.
IS–LM model: A macroeconomic model of
aggregate demand that assumes that the central
banks targets the money supply.
LM curve: A curve that shows the combinations
of the interest rate and the output gap that result in
equilibrium in the money market.
MP curve A curve in the IS–MP model that
represents Federal Reserve monetary policy.
Multiplier The change in equilibrium GDP
divided by a change in autonomous expenditure.
Multiplier effect The process by which a change
in autonomous expenditure leads to a larger
change in equilibrium GDP.
Okun’s law A statistical relationship discovered
by Arthur Okun between the output gap and the
cyclical rate of unemployment.
Output gap The percentage difference between
real GDP and potential GDP.
Phillips curve A curve that shows the short-run
relationship between the output gap (or the
unemployment rate) and the inflation rate.
Potential GDP The level of real GDP attained
when all firms are producing at capacity.
Chapter Outline
Teaching Tips
Instructors whose courses emphasize policy will want to devote significant class time to the material
in this chapter, which extends the discussion of monetary theory begun in the previous chapter.
This chapter introduces the IS-MP model, which shifts the focus from the central bank’s targeting
the money supply to the central bank’s targeting the bank lending rate. This change results in a
more realistic and modern approach that allows students to tie what they learn in class to the
policy discussions they encounter in the media. Many students reading texts that use the
traditional IS-LM model are surprised to learn that the Federal Reserve has no targets for M1 and
M2 and that articles in the financial press rarely focus on changes in the money supply. The
authors do include a succinct appendix on the IS-LM model for instructors who wish to cover it.
The chapter concludes with a discussion of monetary transmission mechanisms, including the
economics of the bank lending and balance sheet channels.
The Fed Forecasts the Economy
In determining monetary policy, the Fed’s forecasts of future economic growth are crucial. The Fed
knows that changes in interest rates and the money supply affect the economy with a lag, so policies it
implements today will not have their full effect on the economy for a year or more.
18.1 The IS Curve (pages 551–562)
Learning Objective: Understand what the IS curve is and how it is derived.
A. Equilibrium in the Goods Market
Equilibrium occurs in the goods market when the value of goods and services demanded—
aggregate expenditure, AE—equals the value of goods and services produced—real GDP, Y.
If aggregate expenditure is less than real GDP, inventories will increase. Real GDP and
employment will decline, and the economy will be in a recession (note: the opposite occurs
when aggregate expenditure exceeds real GDP). Studies have shown that households spend
more when their current income is rising and spend less when their current income is falling.
Consumption is related to GDP using the marginal propensity to consumer (MPC) such that C
MPC × Y, where MPC is between 0 and 1. Holding the other components of AE fixed, the
relation between C and Y implies that the slope of the AE curve is equal to the MPC. The goods
market equilibrium can be shown graphically using the AE curve and a 45o line as AE Y. See
figure 18.1 on page 554 of the text for two 45o-line diagrams.
B. Potential GDP and the Multiplier Effect
The Fed’s goal is to have equilibrium GDP close to potential GDP, which is the level of real
GDP attained when all firms are producing at capacity. A decline in autonomous spending leads
to a larger decline in equilibrium GDP due to an induced decline in consumption as households
decrease their spending as their incomes decline. The series of induced changes in consumption
spending that result from an initial change in autonomous expenditure is called the multiplier
effect. The change in equilibrium GDP resulting from a change in autonomous expenditures is
called the multiplier.
C. Constructing the IS Curve
Introducing the real interest rate into the AE model helps to derive the IS curve, which shows
the combination of real interest rates and GDP where the goods market is in equilibrium.
Higher real interest rates lead to a decline in AE, which, in turn, results in a decline in GDP.
D. The Output Gap
The output gap is the percentage difference between real GDP and potential GDP. The IS curve
can be modified to reflect the relationship between real interest rates and the output gap.
E. Shifts of the IS Curve
A demand shock is a change in one of the components of AE that causes the IS curve to shift.
Positive demand shocks shift the IS curve to the right, while negative demand shocks shift the
IS curve to the left.
18.2 The MP Curve and the Phillips Curve (pages 562–570)
Learning Objective: Explain the significance of the MP curve and the Phillips curve.
A. The MP Curve
The IS–MP model assumes that the Fed attempts to control the real interest rate by changing its
target for the federal funds rate. The MP curve is a horizontal line at the real interest rate
determined by the Fed because we assume that the Fed is able to keep the real interest rate
constant. According to the IS-MP model, when the Fed changes the real interest rate, the output
gap changes (that is, a higher real interest rate results in a decline in the output gap).
B. The Phillips Curve
The Fed relies on an inverse relationship between the inflation rate and the state of the economy
When real GDP is below potential GDP, firms operate below their capacity and the
unemployment rate rises, which puts downward pressure on costs and prices, ultimately leading
to a lower inflation rate. A graph showing the short-run relationship between the unemployment
rate and the inflation rate is called a Phillips curve. Economists who have studied the Phillips
curve relationship have concluded that rather than there being a single stable trade-off between
inflation and unemployment, the position of the Phillips curve can shift over time in response to
supply shocks and changes in expectations of the inflation rate. In addition, most economists
believe that the best way to capture the effect of changes in the unemployment rate on the
inflation rate is by looking at the natural rate of unemployment, which is the gap between the
current unemployment rate and the unemployment rate when the economy is at full employment.
C. Okun’s Law and an Output Gap Phillips Curve
Instead of considering the relationship between inflation and cyclical unemployment, we can
use Okun’s Law to derive a Phillips curve that relates inflation to the output gap.
18.3 Equilibrium in the IS-MP Model (pages 570–579)
Learning Objective: Use the IS-MP model to demonstrate macroeconomic equilibrium
A. Using Monetary Policy to Fight a Recession
A negative demand shock results in a decline in AE causing a negative output gap, which puts
downward pressure on inflation. The Fed typically fights recessions by lowering the federal
funds rate so that AE increases, causing the output gap to return to zero and the inflation rate to
return to its previous level.
B. Complications Fighting the Recession of 2007–2009
During the financial crisis of 2007–2009, long-term real interest rates did not respond as they
typically do to the decline in the federal funds rate due to a rise in the risk premium. The
economy began to recover in mid-2009 only after the risk premium began to decline to more
normal levels.
Teaching Tips
The discussion about the complications involved in fighting the recession of 2007–2009 helps to explain the
difference between a typical recession and one caused by a financial crisis. Encourage students to discuss
the role and effectiveness of monetary policy in response to a financial crisis such as that in 2007–2009. One
conclusion is that although monetary policy has an effect, it may be less evident than in a more typical
recession due to high risk premiums.
18.4 Are Interest Rates All That Matter for Monetary Policy? (pages 579–581)
Learning Objective: Discuss alternative channels for monetary policy.
In the IS–MP model, monetary policy works through the channel of interest rates.
A. The Bank Lending Channel
In the bank lending channel, a change in banks’ ability or willingness to lend affects
bank-dependent borrowers’ ability to finance their spending plans. In this channel, a monetary
expansion increases banks’ ability to lend, and increases in loans to bank-dependent borrowers
increase their spending.
B. The Balance Sheet Channel: Monetary Policy and Net Worth
The balance sheet channel describes ways in which, by changing interest rates, monetary policy
affects borrowers’ net worth and spending decisions. Increases in interest rates in response to a
contractionary monetary policy increase the amounts that borrowers with variable-rate loans
pay on their debts and reduce the value of borrowers’ net worth by reducing the present value
of their assets. This fall in net worth raises the cost of external financing by more than the increase
that is implied by higher interest rates, and it reduces firms’ ability to invest in plant and equipment.
Teaching Tips
Solved Problems 18.3 on page 577 of the text shows students how to use the IS-MP model,
step-by-step, to analyze the effects of monetary policy. Many times, students try to memorize
models or skip steps when using models. Encourage students to review the material to better
understand the behavior of each component of the model: specifically, how monetary policy
directly affects the MP curve, the resulting effect on GDP and the effect on inflation shown by
the Phillips curve. Taking a step-by-step approach helps students understand the economics
underlying the model. For further practice, ask students to complete related Problem 3.8 at the
end of the chapter using a step-by-step approach.
18A Appendix: The IS-LM Model (pages 588–591)
Learning Objective: Use the IS-LM model to illustrate macroeconomic equilibrium.
The IS-MP model in the chapter assumes that the Fed is targeting the federal funds rate.
The
IS– LM model in the appendix assumes that the Fed targets the money supply.
A. Deriving the LM curve
The LM curve shows the combination of real interest rates and real GDP that result in equilibrium
in the money market. Holding the supply of real money balances constant in the money market,
higher levels of real GDP are associated with higher levels of the real interest rate.
B. Shifting the LM Curve
The LM curve will shift if factors, other than real GDP, that affect the demand or supply for real
balances change.
C. Monetary Policy in the IS-LM Model
Equilibrium in both the goods market and the money market occur where the IS and LM curves
cross. If the Fed increases real money balances, the LM curve shifts to the right, resulting in
a decline in the real interest rate and an increase in real GDP relative to potential GDP.
