IMF: What Are Economic Models?

One more result from my google search for economic model, this time from the International Monetary Fund. Just to class up the series.

THE MODERN ECONOMY is a complex machine...

So far, so good.

An economic model is a simplified description of reality, designed to yield hypotheses about economic behavior that can be tested.

Oops. "Designed to yield hypotheses about human behavior". Nope, that's micro economics. Why is this so hard for people to understand???

If the economy was really good, maybe I could see it. But it's not good, and it hasn't been good for years. And it wasn't good 10 years ago, and it wasn't good 30 years ago, and it wasn't good 40 years ago. Mostly, it's not good anymore.

You think that's because of human behavior? Pffft! There are macro problems.

It's because of monetary balances: changes in monetary balances over generations. You know: You call it inequitable distribution of wealth and income. That's part of it.

There are two broad classes of economic models—theoretical and empirical. Theoretical models seek to derive verifiable implications about economic behavior under the assumption that agents maximize specific objectives subject to constraints that are well defined in the model (for example, an agent’s budget).

Behavior, again.

In contrast, empirical models aim to verify the qualitative predictions of theoretical models and convert these predictions to precise, numerical outcomes.

Boy, that sounds awfully empty to me. You think the concentration of wealth is because of economic behavior? You think the stagnation of median family income is because of behavior? You think unacceptable levels of unemployment is because of behavior? I don't.

Despite their diversity, empirical economic models have features in common. Each will allow for inputs, or exogenous variables, which do not need to be explained by the model. These include policy variables, such as government spending and tax rates, or nonpolicy variables, like the weather. Then there are the outputs, called dependent variables (for example, the inflation rate), which the model will seek to explain when some or all of the exogenous variables come into play.

Every empirical model will also have coefficients that determine how a dependent variable changes when an input changes (for example, the responsiveness of household consumption to a $100 decrease in income tax). Such coefficients are usually estimated (assigned numbers) based on historical data. Last, empirical model builders add a catchall variable to each behavioral equation to account for idiosyncrasies of economic behavior at the individual level. (In the example above, agents will not respond identically to a $100 tax rebate.)

So: We should concern ourselves with government spending and tax rates, and the weather, and the coefficients, and the response to a hundred-dollar tax cut. And that's how we should explain the economy?

Not on my blog.

All economic models, no matter how complicated, are subjective approximations of reality designed to explain observed phenomena. It follows that the model’s predictions must be tempered by the randomness of the underlying data it seeks to explain and by the validity of the theories used to derive its equations.

A good example is the ongoing debate over existing models’ failure to predict or untangle the reasons for the recent global financial crisis. Insufficient attention to the links between overall demand, wealth, and—in particular—excessive financial risk taking has been blamed. In the next few years there will be considerable research into uncovering and understanding the lessons from the crisis. This research will add new behavioral equations to current economic models.

In particular, "excessive financial risk taking" is a microeconomic phenomenon. The problem is not that some people were taking excessive financial risk. The problem is that the accumulation of financial risk became too great, because the accumulation of financing became too great, because policymakers thought it was a good thing and they encouraged it, right up to the end.

Their policies are the problem. Our policies.

// Part 4 of 4