In the last 20–30 years of the twentieth century a peculiar disconnect developed between the kind of economic policy model that was taught in universities and the practice of economic policy and monetary policy in particular. Over time the disconnect widened so that the theoretical and empirical models used to inform and analyse policy actions were equally disconnected from what was still being taught in universities. The issue obviously is that the latter remained the venerable IS-LM first introduced by John Hicks (1937) in the UK and Alvin Hansen in the United States (1938). That model remains the simplest and most intuitive one that many introductory textbooks still use.1 But understandably the disconnect referred to above created many problems because so many contemporary policy decisions could only be represented in that context with convoluted and implausible steps. Understandably the search for a model that could bridge the gap and eliminate the disconnect started in earnest. The bulk of this book is dedicated to – arguably – the most versatile of such replacements: the three-equations model pioneered by Carlin and Soskice (2006, 2009, 2014).

Why is the IS-LM model no longer suitable?

To understand why the IS-LM model has to be abandoned it is useful to distinguish between two separate sets of problems about it. One set was always there from the very beginning and its existence had been known since the 1930s, but the other advantages of the model, in terms of its simplicity and intuitiveness, were enough to compensate. These problems are the following.

First, the IS is in flow terms whereas the LM is in stock terms. That is, one relationship measures the amount of consumption, investment, and net exports per unit of time, while the other is a statement of how much liquid money there is at a specific point in time. This mismatch was essentially unavoidable because the IS-LM model was intended to be a mathematical/diagrammatic translation of what Keynes had written in the General Theory (1936), and such a mismatch was already there.

Second, the IS depends on the real interest rate (r) whereas the LM depends on the nominal interest rate (i).