The text reads as follows: I S Curve: Illustrates how lower real interest rates raise spending and hence G D P, leading to a positive output gap. Decrease in interest rate leads to increase in consumption, increase in G or increase in N X leads to increase in G D P resulting in increase in output gap.

The graph plots output gap against real interest rate and depicts a downward-sloping I S curve. The point (0, 4) on the I S curve denotes the changes in r causing a movement along the I S curve. Dashed lines connect the point (0, 4) to the vertical and horizontal axes. The text along the dashed lines read, Use the I S curve to forecast the output gap.

M P curve: illustrates the current real interest rate, which is shaped by monetary policy and the risk premium. Interest rate equals risk-free interest rate (monetary policy) plus risk premium (financial markets). The graph plots output graph against real interest rate and a straight line parallel to the horizontal axis that starts on the vertical axis at 4 percent depicts the M P curve. The risk premium equals extra interest that lenders charge to account for risk. Risk-free interest rate equals the interest rate on a loan that involves no risk. Set by the Fed.

I S-M P framework

A graph plots output gap against real interest rate and a straight line parallel to the horizontal axis that starts on the vertical axis at 4 percent depicts the M P curve. The downward-sloping I S curve intersects the M P curve at equilibrium and a dashed line connects this point to the horizontal axis and denotes the Equilibrium output gap. An arrow pointing from the point depicting Equilibrium is accompanied by a text that reads, the state of the economy is determined by the intersection of the I S curve and M P curve. An arrow pointing towards the output gap is accompanied by a text that reads, G D P, relative to potential.

Effects of Macroeconomic shock

1. Is there a spending shock (which shifts the I S curve), or a financial shock (which shifts the M P curve)?

2. Where does this shift the I S curve of M P curve?

3. What happens to G D P in the new equilibrium?

A graph plots output gap against real interest rate (from 0 to 6 percent) and a straight line parallel to the horizontal axis that starts on the vertical axis at 4 percent depicts the M P curve. The downward-sloping I S curve intersects the M P curve at old equilibrium. Upward and downward arrows depict that Upward shift in M P results from increase in risk premium and increase in risk-free rate and decreased risk premium and decreased risk-free rate, respectively. Decrease in C, I, G, and N X results in the shift of I S curve to the left and increase in C, I, G, or N X results in the shift of the I S curve to the right.

An arrow points to a note next to the M P curve and reads, Shifts M P Curve: The risk premium rises if lending becomes riskier. The risk-free rate rises in response to monetary policy.

An arrow points to a note next to the I S curve and reads, Shifts I S curve (by delta spending times multiplier): Consumption (C) rises when people feel more prosperous. Planned investment (I) rises if its profitable to expand production. Government spending (G) rises in response to expansionary fiscal policy. Net exports (N X) rise in response to global factors.