Simple models have the capability to help us understand a complex economy due to how simplicity offers understanding. There are some examples of economic models, such as the Mundell-Fleming Model, the classical model, the Production Possibility Frontier, the business cycle, and the Keynesian IS/LM Model.
Mundell-Fleming Model
The Mundell-Fleming Model was founded by Robert Mundell and Marcus Fleming. The model illustrates how it is impossible for an economy to sustain a fixed exchange rate, independent monetary policies, and the free movement of capital all at the same time. An economy only has the capacity to sustain two of the three aspects simultaneously. Here is a depiction of what happens when there is a change in monetary policy.
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In the model, monetary policy (LM) decreases in terms of interest rates. This results in an increase in income and output, especially in the private sector. The drop in interest rates is combined with a drop in public spending (IS). The balance of payment (BoP) shows the intersection where monetary and fiscal policy cross over.
Classical Model
The classical economic model was founded by Adam Smith, whom many regard as the father of economics. His model is founded on the assumptions that the economy is always at full employment and prices and wages are flexible.
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In the model, demand for labor (D) drops. This combines with the decrease in wages. Consequently, the supply of labor (S) will also drop.
Production Possibility Frontier
Austrian-American economist Gottfried von Haberler is widely regarded as the founder of the Production Possibility Frontier. The graph is rooted in the concept of opportunity cost and considers the production of two goods. It weighs out how much of the two products a producer can produce with a fixed amount of labor and resources. A level of production outside (to the right) of the curve would require some or all input to be increased.
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When the producer produces the maximum amount of product B, they can't produce anything of product A. The more production the producer then gives up of Product B, the more they can produce Product A. The curve can thus also be considered as the amount of labor and resources allocated to the production of each good.
Business Cycles
Economies tend to function in cycles. These cycles are comprised of ups, downs, and stages in-between. The business cycle model illustrates these stages graphically in terms of time and gross domestic product (GDP).
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Point A shows the growth stage known as the expansion zone where the economy is experiencing rapid growth. Point B illustrates the peak, a phase where the economy has momentarily reached its highest point of GDP growth. Following the peak is point C which depicts a recession, the zone where the economy is suffering and becoming poorer. Point D then shows the time at which the economy is at its worst. Unemployment is high and consumers can't afford much. This stage is then again followed by a recovery that becomes an expansion again. The trendline (TL) illustrates how the cycle as a whole has a tendency to trend upward.
Keynesian IS/LM Model
The Keynesian Model was founded by English economist John Maynard Keynes. It closely relates to the theory of Mundell and Fleming with respect to monetary and fiscal policy.
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The increase in fiscal policy (IS) equals an increase in monetary policy (LM). On the axes, this is illustrated as an interest rate hike along with surging output due to the government's increased involvement in the economy with regard to public spending and policy.
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