Economic model

An economic model is a theoretical

construct representing economic
processes by a set of variables and a set
of logical and/or quantitative relationships
between them. The economic model is a
simplified, often mathematical, framework
designed to illustrate complex processes.
Frequently, economic models posit
structural parameters.[1] A model may
have various exogenous variables, and
those variables may change to create
various responses by economic variables.
Methodological uses of models include
investigation, theorizing, and fitting
theories to the world.[2]

A diagram of the IS/LM model

Overview
In general terms, economic models have
two functions: first as a simplification of
and abstraction from observed data, and
second as a means of selection of data
based on a paradigm of econometric
study.

Simplification is particularly important for

economics given the enormous
complexity of economic processes.[3] This
complexity can be attributed to the
diversity of factors that determine
economic activity; these factors include:
individual and cooperative decision
processes, resource limitations,
environmental and geographical
constraints, institutional and legal
requirements and purely random
fluctuations. Economists therefore must
make a reasoned choice of which
variables and which relationships between
these variables are relevant and which
ways of analyzing and presenting this
information are useful.

Selection is important because the nature

of an economic model will often determine
what facts will be looked at and how they
will be compiled. For example, inflation is
a general economic concept, but to
measure inflation requires a model of
behavior, so that an economist can
differentiate between changes in relative
prices and changes in price that are to be
attributed to inflation.
In addition to their professional academic
interest, uses of models include:

Forecasting economic activity in a way

in which conclusions are logically
related to assumptions;
Proposing economic policy to modify
future economic activity;
Presenting reasoned arguments to
politically justify economic policy at the
national level, to explain and influence
company strategy at the level of the
firm, or to provide intelligent advice for
household economic decisions at the
level of households.
Planning and allocation, in the case of
centrally planned economies, and on a
smaller scale in logistics and
management of businesses.
In finance, predictive models have been
used since the 1980s for trading
(investment and speculation). For
example, emerging market bonds were
often traded based on economic models
predicting the growth of the developing
nation issuing them. Since the 1990s
many long-term risk management
models have incorporated economic
relationships between simulated
variables in an attempt to detect high-
 exposure future scenarios (often
through a Monte Carlo method).

A model establishes an argumentative

framework for applying logic and
mathematics that can be independently
discussed and tested and that can be
applied in various instances. Policies and
arguments that rely on economic models
have a clear basis for soundness, namely
the validity of the supporting model.

Economic models in current use do not

pretend to be theories of everything
economic; any such pretensions would
immediately be thwarted by computational
infeasibility and the incompleteness or
lack of theories for various types of
economic behavior. Therefore,
conclusions drawn from models will be
approximate representations of economic
facts. However, properly constructed
models can remove extraneous
information and isolate useful
approximations of key relationships. In
this way more can be understood about
the relationships in question than by trying
to understand the entire economic
process.

The details of model construction vary

with type of model and its application, but
a generic process can be identified.
Generally, any modelling process has two
steps: generating a model, then checking
the model for accuracy (sometimes called
diagnostics). The diagnostic step is
important because a model is only useful
to the extent that it accurately mirrors the
relationships that it purports to describe.
Creating and diagnosing a model is
frequently an iterative process in which the
model is modified (and hopefully
improved) with each iteration of diagnosis
and respecification. Once a satisfactory
model is found, it should be double
checked by applying it to a different data
set.
Types of models
According to whether all the model
variables are deterministic, economic
models can be classified as stochastic or
non-stochastic models; according to
whether all the variables are quantitative,
economic models are classified as
discrete or continuous choice model;
according to the model's intended
purpose/function, it can be classified as
quantitative or qualitative; according to the
model's ambit, it can be classified as a
general equilibrium model, a partial
equilibrium model, or even a non-
equilibrium model; according to the
economic agent's characteristics, models
can be classified as rational agent models,
representative agent models etc.

Stochastic models are formulated using

stochastic processes. They model
economically observable values over
time. Most of econometrics is based on
statistics to formulate and test
hypotheses about these processes or
estimate parameters for them. A widely
used bargaining class of simple
econometric models popularized by
Tinbergen and later Wold are
autoregressive models, in which the
stochastic process satisfies some
relation between current and past
values. Examples of these are
autoregressive moving average models
and related ones such as autoregressive
conditional heteroskedasticity (ARCH)
and GARCH models for the modelling of
heteroskedasticity.
Non-stochastic models may be purely
qualitative (for example, relating to
social choice theory) or quantitative
(involving rationalization of financial
variables, for example with hyperbolic
coordinates, and/or specific forms of
functional relationships between
variables). In some cases economic
predictions in a coincidence of a model
merely assert the direction of movement
of economic variables, and so the
functional relationships are used only
stoical in a qualitative sense: for
example, if the price of an item
increases, then the demand for that item
will decrease. For such models,
economists often use two-dimensional
graphs instead of functions.
Qualitative models – although almost
all economic models involve some form
of mathematical or quantitative
analysis, qualitative models are
occasionally used. One example is
qualitative scenario planning in which
possible future events are played out.
 Another example is non-numerical
decision tree analysis. Qualitative
models often suffer from lack of
precision.

At a more practical level, quantitative

modelling is applied to many areas of
economics and several methodologies
have evolved more or less independently
of each other. As a result, no overall model
taxonomy is naturally available. We can
nonetheless provide a few examples that
illustrate some particularly relevant points
of model construction.

An accounting model is one based on

the premise that for every credit there is
a debit. More symbolically, an
accounting model expresses some
principle of conservation in the form
algebraic sum of inflows = sinks −
sources

This principle is certainly true for money

and it is the basis for national income
accounting. Accounting models are true
by convention, that is any experimental
failure to confirm them, would be
attributed to fraud, arithmetic error or an
extraneous injection (or destruction) of
cash, which we would interpret as
showing the experiment was conducted
improperly.
Optimality and constrained optimization
models – Other examples of
quantitative models are based on
principles such as profit or utility
maximization. An example of such a
model is given by the comparative
statics of taxation on the profit-
maximizing firm. The profit of a firm is
given by

where is the price that a product

commands in the market if it is supplied
at the rate , is the revenue
obtained from selling the product,
is the cost of bringing the product to
market at the rate , and is the tax that
the firm must pay per unit of the product
sold.

The profit maximization assumption

states that a firm will produce at the
output rate x if that rate maximizes the
firm's profit. Using differential calculus
we can obtain conditions on x under
which this holds. The first order
maximization condition for x is

Regarding x as an implicitly defined

function of t by this equation (see
implicit function theorem), one
concludes that the derivative of x with
respect to t has the same sign as

which is negative if the second order

conditions for a local maximum are
satisfied.

Thus the profit maximization model

predicts something about the effect of
taxation on output, namely that output
decreases with increased taxation. If the
predictions of the model fail, we
conclude that the profit maximization
hypothesis was false; this should lead to
alternate theories of the firm, for
example based on bounded rationality.

Borrowing a notion apparently first used

in economics by Paul Samuelson, this
model of taxation and the predicted
dependency of output on the tax rate,
illustrates an operationally meaningful
theorem; that is one requiring some
economically meaningful assumption
that is falsifiable under certain
conditions.

Aggregate models. Macroeconomics

needs to deal with aggregate quantities
such as output, the price level, the
interest rate and so on. Now real output
is actually a vector of goods and
services, such as cars, passenger
airplanes, computers, food items,
secretarial services, home repair
services etc. Similarly price is the vector
of individual prices of goods and
services. Models in which the vector
nature of the quantities is maintained
are used in practice, for example
Leontief input–output models are of this
kind. However, for the most part, these
models are computationally much
harder to deal with and harder to use as
tools for qualitative analysis. For this
reason, macroeconomic models usually
lump together different variables into a
 single quantity such as output or price.
Moreover, quantitative relationships
between these aggregate variables are
often parts of important
macroeconomic theories. This process
of aggregation and functional
dependency between various
aggregates usually is interpreted
statistically and validated by
econometrics. For instance, one
ingredient of the Keynesian model is a
functional relationship between
consumption and national income: C =
C(Y). This relationship plays an
important role in Keynesian analysis.

Problems with economic

Problems with economic
models
Most economic models rest on a number
of assumptions that are not entirely
realistic. For example, agents are often
assumed to have perfect information, and
markets are often assumed to clear
without friction. Or, the model may omit
issues that are important to the question
being considered, such as externalities.
Any analysis of the results of an economic
model must therefore consider the extent
to which these results may be
compromised by inaccuracies in these
assumptions, and a large literature has
grown up discussing problems with
economic models, or at least asserting
that their results are unreliable.

History
One of the major problems addressed by
economic models has been understanding
economic growth. An early attempt to
provide a technique to approach this came
from the French physiocratic school in the
eighteenth century. Among these
economists, François Quesnay was known
particularly for his development and use of
tables he called Tableaux économiques.
These tables have in fact been interpreted
in more modern terminology as a Leontiev
model, see the Phillips reference below.

All through the 18th century (that is, well

before the founding of modern political
economy, conventionally marked by Adam
Smith's 1776 Wealth of Nations), simple
probabilistic models were used to
understand the economics of insurance.
This was a natural extrapolation of the
theory of gambling, and played an
important role both in the development of
probability theory itself and in the
development of actuarial science. Many of
the giants of 18th century mathematics
contributed to this field. Around 1730, De
Moivre addressed some of these problems
in the 3rd edition of The Doctrine of
Chances. Even earlier (1709), Nicolas
Bernoulli studies problems related to
savings and interest in the Ars
Conjectandi. In 1730, Daniel Bernoulli
studied "moral probability" in his book
Mensura Sortis, where he introduced what
would today be called "logarithmic utility
of money" and applied it to gambling and
insurance problems, including a solution
of the paradoxical Saint Petersburg
problem. All of these developments were
summarized by Laplace in his Analytical
Theory of Probabilities (1812). Thus, by
the time David Ricardo came along he had
a well-established mathematical basis to
draw from.

Tests of macroeconomic
predictions
In the late 1980s, the Brookings Institution
compared 12 leading macroeconomic
models available at the time. They
compared the models' predictions for how
the economy would respond to specific
economic shocks (allowing the models to
control for all the variability in the real
world; this was a test of model vs. model,
not a test against the actual outcome).
Although the models simplified the world
and started from a stable, known common
parameters the various models gave
significantly different answers. For
instance, in calculating the impact of a
monetary loosening on output some
models estimated a 3% change in GDP
after one year, and one gave almost no
change, with the rest spread between.[4]

Partly as a result of such experiments,

modern central bankers no longer have as
much confidence that it is possible to 'fine-
tune' the economy as they had in the
1960s and early 1970s. Modern policy
makers tend to use a less activist
approach, explicitly because they lack
confidence that their models will actually
predict where the economy is going, or the
effect of any shock upon it. The new, more
humble, approach sees danger in dramatic
policy changes based on model
predictions, because of several practical
and theoretical limitations in current
macroeconomic models; in addition to the
theoretical pitfalls, (listed above) some
problems specific to aggregate modelling
are:

Limitations in model construction

caused by difficulties in understanding
the underlying mechanisms of the real
economy. (Hence the profusion of
separate models.)
The law of unintended consequences,
on elements of the real economy not yet
included in the model.
The time lag in both receiving data and
the reaction of economic variables to
policy makers attempts to 'steer' them
(mostly through monetary policy) in the
direction that central bankers want them
to move. Milton Friedman has vigorously
argued that these lags are so long and
unpredictably variable that effective
management of the macroeconomy is
impossible.
The difficulty in correctly specifying all
of the parameters (through econometric
measurements) even if the structural
model and data were perfect.
The fact that all the model's
relationships and coefficients are
stochastic, so that the error term
becomes very large quickly, and the
available snapshot of the input
parameters is already out of date.
Modern economic models incorporate
the reaction of the public and market to
the policy maker's actions (through
game theory), and this feedback is
included in modern models (following
 the rational expectations revolution and
Robert Lucas, Jr.'s Lucas critique of non-
microfounded models). If the response
to the decision maker's actions (and
their credibility) must be included in the
model then it becomes much harder to
influence some of the variables
simulated.

Comparison with models in other

sciences

Complex systems specialist and

mathematician David Orrell wrote on this
issue in his book Apollo's Arrow and
explained that the weather, human health
and economics use similar methods of
prediction (mathematical models). Their
systems—the atmosphere, the human
body and the economy—also have similar
levels of complexity. He found that
forecasts fail because the models suffer
from two problems: (i) they cannot capture
the full detail of the underlying system, so
rely on approximate equations; (ii) they are
sensitive to small changes in the exact
form of these equations. This is because
complex systems like the economy or the
climate consist of a delicate balance of
opposing forces, so a slight imbalance in
their representation has big effects. Thus,
predictions of things like economic
recessions are still highly inaccurate,
despite the use of enormous models
running on fast computers.[5] See
Unreasonable ineffectiveness of
mathematics § Economics and finance.

Effects of deterministic chaos on

economic models

Economic and meteorological simulations

may share a fundamental limit to their
predictive powers: chaos. Although the
modern mathematical work on chaotic
systems began in the 1970s the danger of
chaos had been identified and defined in
Econometrica as early as 1958:
 "Good theorising consists to a large
extent in avoiding assumptions ... [with
the property that] a small change in
what is posited will seriously affect the
conclusions."
(William Baumol, Econometrica, 26 see:
Economics on the Edge of Chaos (http://
www.iemss.org/iemss2004/pdf/keynote
s/Keynote_OXLEY.pdf) ).

It is straightforward to design economic

models susceptible to butterfly effects of
initial-condition sensitivity.[6][7]

However, the econometric research

program to identify which variables are
chaotic (if any) has largely concluded that
aggregate macroeconomic variables
probably do not behave chaotically. This
would mean that refinements to the
models could ultimately produce reliable
long-term forecasts. However, the validity
of this conclusion has generated two
challenges:

In 2004 Philip Mirowski challenged this

view and those who hold it, saying that
chaos in economics is suffering from a
biased "crusade" against it by neo-
classical economics in order to preserve
their mathematical models.
The variables in finance may well be
subject to chaos. Also in 2004, the
 University of Canterbury study
Economics on the Edge of Chaos
concludes that after noise is removed
from S&P 500 returns, evidence of
deterministic chaos is found.

More recently, chaos (or the butterfly

effect) has been identified as less
significant than previously thought to
explain prediction errors. Rather, the
predictive power of economics and
meteorology would mostly be limited by
the models themselves and the nature of
their underlying systems (see Comparison
with models in other sciences above).
Critique of hubris in planning

A key strand of free market economic

thinking is that the market's invisible hand
guides an economy to prosperity more
efficiently than central planning using an
economic model. One reason, emphasized
by Friedrich Hayek, is the claim that many
of the true forces shaping the economy
can never be captured in a single plan.
This is an argument that cannot be made
through a conventional (mathematical)
economic model because it says that
there are critical systemic-elements that
will always be omitted from any top-down
analysis of the economy.[8]
Examples of economic
models
Cobb–Douglas model of production
Solow–Swan model of economic
growth
Lucas islands model of money supply
Heckscher–Ohlin model of international
trade
Black–Scholes model of option pricing
AD–AS model a macroeconomic model
of aggregate demand– and supply
IS–LM model the relationship between
interest rates and assets markets
 Ramsey–Cass–Koopmans model of
economic growth
Gordon–Loeb model for cyber security
investments

See also
Economic methodology
Computational economics
Agent-based computational economics
Endogeneity
Financial model

Notes
1. Moffatt, Mike. (2008) About.com Structural
Parameters (http://economics.about.com/o
 d/economicsglossary/g/structuralp.htm)
Archived (https://web.archive.org/web/201
60107121857/http://economics.about.co
m/od/economicsglossary/g/structuralp.ht
m) 2016-01-07 at the Wayback Machine
Economics Glossary; Terms Beginning with
S. Accessed June 19, 2008.
2. Mary S. Morgan, 2008 "models," The New
Palgrave Dictionary of Economics, 2nd
Edition, Abstract (http://www.dictionaryofec
onomics.com/article?id=pde2008_M0003
91) .
Vivian Walsh 1987. "models and theory,"
The New Palgrave: A Dictionary of
Economics, v. 3, pp. 482–83.
3. Friedman, M. (1953). "The Methodology of
Positive Economics". Essays in Positive
Economics (https://archive.org/details/ess
aysinpositive00milt) . Chicago: University
of Chicago Press. ISBN 9780226264035.
4. Frankel, Jeffrey A. (May 1986). "The
Sources of Disagreement Among
International Macro Models and
Implications for Policy Coordination" (http
s://doi.org/10.3386%2Fw1925) . NBER
Working Paper No. 1925.
doi:10.3386/w1925 (https://doi.org/10.338
6%2Fw1925) .
5. "FAQ for Apollo's Arrow Future of
Everything" (http://www.postpythagorean.c
om/FAQ.html) .
www.postpythagorean.com.
 . Paul Wilmott on his early research in
finance: "I quickly dropped ... chaos theory
[as] it was too easy to construct ‘toy
models’ that looked plausible but were
useless in practice." Wilmott, Paul (2009),
Frequently Asked Questions in Quantitative
Finance (https://books.google.com/books?i
d=n4swgjSoMyIC&pg=PT227) , John Wiley
and Sons, p. 227, ISBN 9780470685143
7. Kuchta, Steve (2004), Nonlinearity and
Chaos in Macroeconomics and Financial
Markets (http://www.sp.uconn.edu/~ages/
files/NL_Chaos_and_%20Macro%20-%2042
9%20Essay.pdf) (PDF), University of
Connecticut
 . Hayek, Friedrich (September 1945), "The
Use of Knowledge in Society", American
Economic Review, 35 (4): 519–30,
JSTOR 1809376 (https://www.jstor.org/sta
ble/1809376) .

References
Baumol, William & Blinder, Alan (1982),
Economics: Principles and Policy
(2nd ed.), New York: Harcourt Brace
Jovanovich, ISBN 0-15-518839-9.
Caldwell, Bruce (1994), Beyond
Positivism: Economic Methodology in the
Twentieth Century (Revised ed.), New
York: Routledge, ISBN 0-415-10911-6.
Holcombe, R. (1989), Economic Models
and Methodology, New York: Greenwood
Press, ISBN 0-313-26679-4. Defines
model by analogy with maps, an idea
borrowed from Baumol and Blinder.
Discusses deduction within models, and
logical derivation of one model from
another. Chapter 9 compares the
neoclassical school and the Austrian
School, in particular in relation to
falsifiability.
Lange, Oskar (1945), "The Scope and
Method of Economics", Review of
Economic Studies, The Review of
Economic Studies Ltd., 13 (1): 19–32,
doi:10.2307/2296113 (https://doi.org/1
0.2307%2F2296113) , JSTOR 2296113
(https://www.jstor.org/stable/2296113)
, S2CID 4140287 (https://api.semanticsc
holar.org/CorpusID:4140287) . One of
the earliest studies on methodology of
economics, analysing the postulate of
rationality.
de Marchi, N. B. & Blaug, M. (1991),
Appraising Economic Theories: Studies in
the Methodology of Research Programs
(https://archive.org/details/appraisinge
conom0000unse) , Brookfield, VT:
Edward Elgar, ISBN 1-85278-515-2. A
series of essays and papers analysing
questions about how (and whether)
models and theories in economics are
empirically verified and the current
status of positivism in economics.
Morishima, Michio (1976), The Economic
Theory of Modern Society (https://archiv
e.org/details/economictheoryof0000m
ori) , New York: Cambridge University
Press, ISBN 0-521-21088-7. A thorough
discussion of many quantitative models
used in modern economic theory. Also a
careful discussion of aggregation.
Orrell, David (2007), Apollo's Arrow: The
Science of Prediction and the Future of
Everything (https://archive.org/details/a
pollosarrowscie0000orre) , Toronto:
Harper Collins Canada, ISBN 978-0-00-
200740-5.
Phillips, Almarin (1955), "The Tableau
Économique as a Simple Leontief
Model", Quarterly Journal of Economics,
The MIT Press, 69 (1): 137–44,
doi:10.2307/1884854 (https://doi.org/1
0.2307%2F1884854) , JSTOR 1884854
(https://www.jstor.org/stable/1884854)
.
Samuelson, Paul A. (1948), "The Simple
Mathematics of Income Determination",
in Metzler, Lloyd A. (ed.), Income,
Employment and Public Policy; essays in
honor of Alvin Hansen, New York: W. W.
Norton.
Samuelson, Paul A. (1983), Foundations
of Economic Analysis (Enlarged ed.),
Cambridge: Harvard University Press,
ISBN 0-674-31301-1. This is a classic
book carefully discussing comparative
statics in microeconomics, though
some dynamics is studied as well as
some macroeconomic theory. This
should not be confused with
Samuelson's popular textbook.
Tinbergen, Jan (1939), Statistical Testing
of Business Cycle Theories, Geneva:
League of Nations.
Walsh, Vivian (1987), "Models and
theory", The New Palgrave: A Dictionary
of Economics, vol. 3, New York: Stockton
Press, pp. 482–83, ISBN 0-935859-10-1.
Wold, H. (1938), A Study in the Analysis
of Stationary Time Series, Stockholm:
Almqvist and Wicksell.
Wold, H. & Jureen, L. (1953), Demand
Analysis: A Study in Econometrics, New
York: Wiley.
Gordon, Lawrence A.; Loeb, Martin P.
(November 2002). "The Economics of
Information Security Investment" (http://
tissec.acm.org/) . ACM Transactions on
Information and System Security. 5 (4):
 438–457. doi:10.1145/581271.581274
(https://doi.org/10.1145%2F581271.58
1274) . S2CID 1500788 (https://api.sem
anticscholar.org/CorpusID:1500788) .

External links
Wikiquote has quotations related to
Economic model.
Wikimedia Commons has media related
to Economic models.
R. Frigg and S. Hartmann, Models in
Science (http://plato.stanford.edu/entrie
s/models-science/) . Entry in the
Stanford Encyclopedia of Philosophy.
H. Varian How to build a model in your
spare time (http://www.sims.berkeley.ed
u/~hal/Papers/how.pdf) The author
makes several unexpected suggestions:
Look for a model in the real world, not in
journals. Look at the literature later, not
sooner.
Elmer G. Wiens: Classical & Keynesian
AD-AS Model (http://www.egwald.ca/ma
croeconomics/keynesian.php) – An on-
line, interactive model of the Canadian
Economy.
IFs Economic Sub-Model [1] (http://ww
w.ifs.du.edu/ifs) : Online Global Model
Economic attractor (https://web.archive.
org/web/20131220102737/http://www.
bentamari.com/attractors)
 Portal: Business and economics

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