Welcome to the deep dive. If you're joining us
today, you're probably already tracking the complexities
of macroeconomic policy. Yeah. Or maybe you're
prepping for an economics class. Right. Or just,
you know, trying to make sense of the financial
news when they talk about the Federal Reserve.
Or you're just insanely curious about how the
economy actually works behind the scenes. Which
is a great reason to be here. It is. Because
today our mission is to thoroughly unpack a single,
honestly quite dense Wikipedia article. It's
about the ISMP model. The investment savings
monetary policy model. Exactly. And we're going
to build a mental map of the economy using just
a few key variables. We're talking interest rates,
inflation, output, consumer spending, and of
course, the Federal Reserve. And I know that
sounds like dry academia. A little bit, yeah.
But it's actually not. It's really the source
code for how central banks attempt to manage
our reality. That's how they map out their decisions.
And we even have a surprising academic rivalry
to get into later on. Oh yeah, the controversy.
Right, about whether this model, which is widely
used, actually hides the most important parts
of the economy. But let's start with the blueprint.
What is the ISMP model? Let's lay the foundation.
So the core definition from the text we're looking
at says, the ISMP model is a macroeconomic tool
specifically designed to display short run fluctuations.
And we really need to emphasize that phrase,
short run fluctuations. Why is that so critical?
Because in macroeconomics, the difference between
the short run and the long run is, well, it changes
the entire physics of the economy you're looking
at. OK, so what does short run imply here? It
implies that certain things in the economy haven't
had time to adjust yet. Specifically, prices
and wages. We call them sticky. Sticky prices.
Right. If the central bank suddenly changes the
interest rate today, your local coffee shop doesn't
instantly print new menus with lower prices.
Yeah, that takes time. Exactly. And your boss
doesn't immediately call you in to renegotiate
your salary because those prices are sticky.
A shift in monetary policy has a very real immediate
impact on actual economic output and employment.
Got it. So the ISMP model is mapping that specific
window of turbulence, the immediate reaction.
Yeah, the reactive phase before the broader economy
has time to reach some new long -term equilibrium.
OK, so in this short run window, the text lists
three main things this model tracks, the holy
trinity of variables here, the interest rate,
inflation, and output. Those three are inherently
linked in this closed system. It kind of reminds
me of a dashboard in a car. How so? Like if you
change one dial, say you tweak the monetary policy
dial, it automatically forces the needles to
move on the other gauges, like inflation and
output. You can't just change one thing in isolation.
That is a perfect analogy. It's a highly interconnected
machine. And to understand the whole machine,
we really have to look at the individual gears
first. Let's do that. Let's look at the first
gear, the MP curve. The Federal Reserve's main
lever. Right. MP stands for monetary policy.
So I want you, the listener, to visualize a graph
with us, just a basic two -axis graph. Keep it
simple in your mind. The vertical axis, the y
-axis going up and down, is the real interest
rate. OK. And the horizontal axis, the x -axis
going left or right, is the inflation rate. Right.
And the text points out that the MP curve displays
a positive relationship. It's an upward sloping
curve. Upward sloping, meaning as inflation moves
right, meaning it increases. The real interest
rate moves up. But why? Like physically, what
is driving that positive relationship? Well,
the driver of that entire line is the Federal
Reserve or whichever central bank you're looking
at. The upward slope isn't some natural law of
nature. It's a mechanical rule built into the
model to represent how the Fed behaves. OK, so
it's mapping human policy decisions. Exactly.
When inflation starts to heat up, moving to the
right on your mental graph, the central bank
reacts by raising the real interest rate to cool
things down. They hike rates. To make borrowing
more expensive. Right. And if inflation drops,
they lower rates to stimulate things. So the
curve slopes upward because it mathematically
assumes the central bank is always going to fight
inflation by raising the cost of borrowing. So
a movement along that curve is just the Fed doing
its normal day to day job. Right. Just following
the standard playbook. But the text gives us
a specific scenario where the Fed takes a much
bigger action. It talks about a target decrease
in the federal funds rate. Now, that is different.
That is a regime change. And the text says, this
action shifts the entire MP curve to the right.
Not just moving along the line, but picking the
whole line up and shoving it to the right. Right.
And let's painfully break down the dual outcome
the text explicitly states here, because this
is huge. It says, shifting the MP curve right
results in a decrease in the real interest rate
and an increase in the inflation rate. And that
right there is the fundamental trade -off of
monetary policy. It's the package deal. Exactly.
When the Fed steps in to artificially lower their
target rate, they are explicitly accepting a
trade -off. They are saying, we want lower real
interest rates to help the economy, but we know
the mathematical cost of that is higher inflation.
You can't get one without the other. You really
can't. And that's why understanding this model
matters so much for anyone trying to decipher
policy. It removes the illusion that central
bankers have magic wands. They just have levers.
Levers with very strict consequences. OK, let's
switch gears to the second half of the model.
We've got the MP curve. Now we need the IS curve.
Investment savings. Right. And this represents
basically everyone else. Consumers, the government,
total output. A real physical economy. So let's
redraw our mental graph. The vertical axis remains
the real interest rate. Same as before. But now,
the horizontal axis is not inflation. It's total
output, which the text labels as Q. Total output,
Q. Basically think of it as gross domestic product,
all the goods and services we produce. Now here
is a crucial difference. The text highlights
that the IS curve is a negative relationship.
It slopes downward. Right. From top left down
to bottom right. And the core rule from the text
is that an increase in the interest rate produces
lower total output, Q. Which makes intuitive
sense if you think about how normal people and
businesses operate. Walk us through that. If
the real interest rate is really high, so you're
way up on that vertical axis, it means borrowing
money is incredibly expensive. Mortgages are
high. Car loans are high. Exactly. So what happens?
You don't buy the new car. A business decides
not to build that new warehouse because the loan
is too expensive. They just save their money
instead. Right. And because everyone stops borrowing
and spending, total output Q shrinks, it moves
to the left. But as interest rates drop, loans
get cheap, people buy things, businesses expand,
and output moves to the right. It grows. So if
we connect this back to the M key curve we just
talked about, if the Fed fights inflation and
interest rates go up, that directly crushes total
output on the IS curve. You're seeing the connection.
Yes. But who actually moves the IS curve? Because
the Fed moves the MP curve. Who has the steering
wheel for IS? The text notes it's the actions
of the government and consumers. So not the central
bank? No. The Fed has no direct control over
the IS curve itself. They only control the interest
rate on the vertical axis. OK, so the text gives
another step -by -step scenario for this side
of the model. The action is an increase in either
consumer spending or government spending. Like
a massive stimulus bill. Right, like an infrastructure
package. The movement from that action, according
to the text, is the IS curve shifts rightwards.
The whole line moves right. And the result, and
this is a key phrase, this results in an increase
in total output for any level of the interest
rate. That phrase is everything. For any level
of the interest rate. Meaning the government
can just brute force economic growth, even if
borrowing is expensive. Precisely. If the government
just dumps a trillion dollars into building roads
and bridges, that directly injects demand into
the system. It doesn't matter if the interest
rate is high or low at that exact moment. That
sheer volume of spending forces total output,
Q, to expand outward. So summarizing this, the
Fed controls the MP curve. You, the consumer,
and the government, you control the IS curve.
That's the setup. So let's crash them together.
Section 4, analyzing the intersection. The chain
reaction. This is where the model actually comes
alive. We bring both curves onto the same graph.
Where they cross is the current state of the
economy. And the text has a very specific analysis
example that I want to walk through, like, really
slowly. Economic dominoes falling. Let's do it.
OK, domino one, a lowering of the federal funds
target. The central bankers make their decision.
Domino two, the MP curve shifts to the right.
The policy takes effect on the graph. Domino
three. we get a lower interest rate and higher
inflation. The mechanical trade -off we discussed.
The cost of borrowing drops. And here is Domino
Four, the crossover. The text says this newly
lowered interest rate causes a downward movement
along the IS curve. Notice it says a movement
along the curve, not a shift of the curve. Right.
And this was kind of an aha moment for me reading
this, because the output of the MP curve, that
new lower interest rate, it literally becomes
the input for the IS curve. Yes. It's a handoff.
The central bank did their part. They lowered
the rate. Now the consumers and the businesses
react to that new low rate. They slide down their
existing demand curve. Because debt is cheap
again. Exactly. And that leads to the final domino.
Domino five. Output increases. The grand finale.
The elegant machine at work. The Fed pulls a
lever in a boardroom, which manipulates the MP
curve, which lowers the interest rate, which
slides down the consumer and government IS curve,
ultimately resulting in a boom in total output.
Cue. It's honestly beautiful when you lay it
out like that. It's a very satisfying tool for
economists to use. It maps cause and effect so
cleanly. But it wasn't always the standard tool,
was it? No, not at all. Yeah, the text introduces
an older model, the predecessor. It's called
the ISLM model. The classic ISLM. OK. If you
took econ a few decades ago, this is what you
lived and breathed. So defining ISLM, the text
notes, it describes equilibrium in two markets,
the commodity market and the money market. Right.
The IS part is the exact same. Investment savings,
the commodity market, the real economy. But the
LM part is different. LM stands for liquidity
preference and money supply. So why do we have
ISMP now? The text specifically calls ISMP an
upgraded version. What was wrong with the old
one? Well, the text says the upgrade better reflects
the impact of monetary policy and the central
bank's role in managing the economy. Meaning
the central banks changed how they operate in
the real world. Exactly. Under the old ISLM model,
The assumption was that a central bank controlled
the economy by strictly managing the actual supply
of physical money, the quantity of dollars out
there. But they don't really do that anymore.
Not primarily, no. Modern central banks shifted
to targeting specific short term interest rates
instead. They adjust the rates and they let the
money supply kind of float to whatever level
is needed to maintain that rate. So the map had
to change to reflect the new territory. Right.
And the academic context the text gives for this
is really interesting. It cites a foundational
paper from the year 2000. By David Romer. Yes.
Titled Keynesian macroeconomics without the LM
curve. Without the LM curve. So Romer just straight
up deleted the money market from the model. He
looked at it and said if central banks aren't
obsessing over the money supply anymore why should
our baseline model obsess over it. He deleted
the LM curve and replaced it with the MP curve
which focuses purely on the central bank's interest
rate actions. It centers the Fed. Completely.
It puts their policy lever right in the spotlight.
OK, but before we get into the pushback on Roemer's
big deletion, because there is pushback, we need
to scale up a bit because the text reminds us
of a major limitation. The short run limitation.
Right. ISMP only displays short run fluctuations.
It's the immediate reaction. But obviously economists
care about what happens next year or five years
from now. You can't just look at the short run.
So the text introduces the bigger picture. It
says the ISMP model is actually used as a foundation
for the ADAS model. ADAS, aggregate demand and
aggregate supply. What's the connection there?
Think of the ISMP model as the engine that powers
the ADAS model. Okay. The ISMP model tells us,
hey, the Fed cut rates today, so output is booming
right now. The ADAS model takes that immediate
boom and tracks how it ripples out over time.
When those sticky prices get unstuck. Exactly,
when the sugar high wears off. Because if output
is booming, eventually companies have to hire
more workers, which drives up wages, which increases
costs, which forces them to finally raise their
prices. Meaning inflation. Systemic long -term
inflation. The text specifically says that when
ISMP is plugged into the ADA framework, economists
can drive long -term movements in inflation and
interest rates. It transitioned from the base
short -run movements to the long -term reality.
So they nest inside each other. ISMP handles
the today, ADAS handles the tomorrow. That's
a great way to put it. Alright, let's get back
to David Romer deleting the money supply from
the model, because not everyone loved this upgraded
version. It was a very bold move, and in economics
bold moves invite serious critiques. And the
text introduces a massive critique from economist
Greg Mankiw. A huge name in the field. And Mankiw
has this great quote in the text. He says, the
ISMP model has quirky features. Which is, in
academic speak, calling a rival's model quirky
is basically throwing down the gauntlet. It's
a very polite insult. Mankiw explicitly prefers
the old ISLM model. He does. And the text gives
us his core argument for why. It says, ISLM focuses
on the important connections between the money
supply, interest rates, and economic activity.
And here's the kicker, whereas the ISMP model
leaves some of that in the background. Leaves
it in the background. That is the fundamental
blind spot Mankiw is pointing out. So Romer wanted
to center the Federal Reserve and interest rates
because that's what they actually talk about
in their press conferences. Right. But Mankiw
is arguing that by doing so, by literally erasing
the money supply curve, you're hiding a massive
structural force in the economy. Mankiw is basically
saying, Just because the Fed isn't staring at
the money supply doesn't mean the money supply
stopped mattering. It's still there. It's definitely
still there. And Mankiw argues that the sheer
quantity of money circulating is a critical driver
of inflation and economic health. If your model
just assumes the money supply will magically
adjust itself in the background without causing
any weird side effects, you're going to get caught
off guard. So who is right? Which is more important
for understanding the economy, the interest rate
lever, or the actual pool of money? Well, it's
a trade off, right? Roemer's model is incredibly
accurate for normal times. When the economy is
functioning normally, the Fed tweaks the interest
rate, and the ISMP model predicts the outcome
beautifully. But what about abnormal times? That's
exactly when Mankiw's critique hits hardest.
So we've taken this massive journey today through
the ISMP model. We really have. We started with
the basic short -run fluctuations of interest
rates, inflation, and output. We mapped out the
Federal Reserve's MP curve and how they trade
higher inflation for lower rates. And we looked
at the IS curve, where consumer and government
spending can drive output regardless of what
the Fed is doing. Right. And then we brought
them together to watch the chain reaction from
the boardroom to the cash register. And we debated
the evolution of the model itself, from ISLM
to ISMP, Roemer versus Manki. There's a lot to
take in. It is. But what is the real listener
value here? Like, why keep this model in your
head? The value is that the next time you hear
a news report saying the central bank is lowering
interest rates, you aren't just hearing abstract
financial jargon anymore. Right, you have the
blueprint. You possess the exact mental blueprint.
You can visualize the MP curve shifting right.
You know exactly how that decision is meant to
cascade down the IS curve, making borrowing cheaper,
to artificially boost total output in the short
run. You can see the matrix. You can see the
matrix. I love that. But I want to leave everyone
with a final provocative thought built on Mankey's
critique. Oh, this is a good one. Because if
the ISMP model became the modern standard by
placing the central bank's interest rate policy
in the spotlight and leaving the actual money
supply in the background, what happens to our
understanding of the economy when those traditional
interest rate tools stop working? Like when interest
rates hit zero? Exactly. When rates hit zero
and the central bank resorts to just printing
trillions of dollars quantitative easing, suddenly
the money supply is the only thing that matters.
But our modern model left that in the background.
Right. Are we relying on a map that is fundamentally
blind to the very money supply we ignored? It
really makes you wonder if our models are shaping
our reality or blinding us to it. A great question
to end on. Thank you for joining this deep dive
and keep questioning the models that shape our
world. We'll see you next time.