12-9-5
The Impossible Trinity - Open University > .
The
IS–LM model, or
Hicks–Hansen model, is a two-dimensional
macroeconomic model which is used as a
pedagogical tool in macroeconomic teaching.
Today, the IS–LM model
is generally accepted as being
imperfect and is
largely absent from teaching at advanced economic levels and from macroeconomic research, but it is still an important pedagogical introductory tool in most undergraduate macroeconomics textbooks.
The IS–LM model shows the importance of various
demand shocks (including the effects of
monetary policy and
fiscal policy) on output and consequently offers an explanation of changes in
national income in the short run when
prices are fixed or
sticky. Hence, the model can be used as a tool to suggest potential levels for appropriate stabilisation policies. It is also used as a building block for the demand side of the economy in more comprehensive models like the
AD–AS model.
The
AD–AS or
aggregate demand–aggregate supply model (also known as the
aggregate supply–aggregate demand or
AS–AD model) is a widely used
macroeconomic model that explains
short-run and
long-run economic changes through the
relationship of aggregate demand (AD) and aggregate supply (AS) in a diagram. It coexists in an older and static version depicting the two variables
output and
price level, and in a newer dynamic version showing output and
inflation (i.e. the change in the price level over time, which is usually of more direct interest).
The AD–AS model was invented around 1950 and became one of the primary simplified representations of macroeconomic issues toward the end of the 1970s when inflation became an important political issue. From around 2000 the modified version of a dynamic AD–AS model, incorporating contemporary monetary policy strategies focusing on inflation targeting and using the interest rate as a primary policy instrument, was developed, gradually superseding the traditional static model version in university-level economics textbooks.
The dynamic AD–AS model can be viewed as a simplified version of the more advanced and complex dynamic stochastic general equilibrium (DSGE) models which are state-of-the-art models used by central banks and other organizations to analyze economic fluctuations. Unlike DSGE models, the dynamic AD–AS model does not provide a microeconomic foundation in the form of optimizing firms and households, but the macroeconomic relationships ultimately posited by the optimizing models are similar to those emerging from the modern-version AD–AS model. At the same time, the latter is much simpler and consequently more easily accessible for students, making it a widespread tool for teaching purposes.
The
Mundell–Fleming model, also known as the
IS-LM-BoP model (or
IS-LM-BP model), is an
economic model first set forth (independently) by
Robert Mundell and
Marcus Fleming. The model is an extension of the
IS–LM model. Whereas the traditional IS-LM model deals with economy under
autarky (or a closed economy), the
Mundell–Fleming model describes a small open economy.
The Mundell–Fleming model portrays the
short-run relationship between an economy's
nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that
an economy cannot simultaneously maintain a
fixed exchange rate, free capital movement, and
an independent monetary policy.
An economy can only maintain two of the three at the same time. This principle is frequently called the "
impossible trinity," "unholy trinity," "irreconcilable trinity," "inconsistent trinity," "policy trilemma," or the "Mundell–Fleming
trilemma."
Option (a): A
stable exchange rate and
free capital flows (but
not an independent monetary policy because setting a domestic interest rate that is different from the world interest rate would undermine a stable exchange rate due to appreciation or depreciation pressure on the domestic currency).
Option (b): An
independent monetary policy and
free capital flows (but
not a stable exchange rate).
Option (c): A
stable exchange rate and
independent monetary policy (but
no free capital flows, which would require the use of
capital controls).
The
aggregate demand–inflation adjustment model builds on the concepts of the
IS–LM model and the
AD–AS models, essentially in terms of
changing interest rates in
response to
fluctuations in inflation rather than as changes in the
money supply in response to changes in the
price level.
The
AD–IA model is a
Keynesian method used to explain economic fluctuations. This model is used to show undergraduate students how shifts in demand or shocks to prices can affect real GDP around potential. The model
assumes that when inflation rises the interest rate rises (monetary policy rule). It also assumes that when real GDP exceeds potential, there is upward pressure on the inflation rate and vice versa.
The model features a
downward-sloping demand curve (AD) and a
horizontal inflation adjustment line (IA). The point where the two lines cross is equal to
potential GDP. A shift in either curve will explain the impact on
real GDP and
inflation in the short run.
American economist,
Herbert Stein propounded
Stein's Law, which he expressed in 1986 as "If something cannot go on forever, it will stop." Stein observed this logic in analyzing economic trends (such as rising
US federal debt in proportion to
GDP, or increasing international
balance of payments deficits) in his analysis: if such a process is limited by external factors, there is no urgency for government intervention to stop it, much less to make it stop immediately, but
it will stop of its own accord. A
paraphrase,
not attributed to Stein, is "Trends that can't continue won't."
AD-IA model w 
