IS-MP Model 1) Suppose the IS curve has the following form: = .015 0.6r a) What is the real interest rate consistent with actual output being at potential? r = 2.5% b) Suppose the central bank sets the real interest rate according to the following equation: r = .025 + 0.06 Solve for short-run equilibrium output. = 0.015 0.6(0.025 + 0.06) = 0 c) Draw the IS and MP curves given above in a graph, with r on the y-axis and on the x-axis. Put = 0 at the center of the horizontal axis. Label the short-run equilibrium level of the output gap and real interest rate. How does your answer differ from the graph from class? The difference from class is that our equation for the real interest rate positively depends on , which introduces an upward slope to the MP curve. In class we simply took the real interest rate as given from the central bank plus the risk premium. d) Suppose the central bank is not following the above equation, and you observe short- run equilibrium output is = 2%. What must be the real interest rate? r = 5.833% e) Find short-run equilibrium output if the central bank used the following equation for setting the real interest rate: r = 0.005 + 0.03 = 14.44%