A model is a representation of a theory or event. An economic model is a simplified representation of economic processes and relationships. This representation can be used to:
- Gain a better understanding of the theory.
- Explain the theory to others.
- Generate hypotheses about economic behavior, that can be compared against economic outcomes.
- Predict the outcome of economic policies.
Elements of an Economic Model
Since a model is a simplification, to create a model, it’s necessary to make assumptions. Examples of assumptions usually made by economists are rational expectations or perfect information. The assumptions cannot contradict each other.
One must be careful to choose the right model for the right task. We have a lot of economic models available, maybe a model can be a good predictor in a certain market, country or time span, but it can fail or be useless in another situation.
Variables are elements that vary. In an economic model, there are endogenous variables and exogenous variables. Endogenous variables are explained in the model, their value is determined by the model. Exogenous variables are not determined by the model. Their value is determined outside the model. An exogenous variable can be endogenous in another model.
Variables are related between each other. Relations are usually shown using mathematical formulas. If the value of a variable changes, it usually affect the value of other variables in the model.
When supplied with values for exogenous variables, economic models outcomes are values of endogenous variables. If the values of exogenous variables are taken from real economic data, the outcome of an economic model can be compared with the real outcome.
Usually, the effect of a change in an exogenous variable can only be seen in the future. Sometimes, exogenous variables are determined by the economic policy. Examples of this kind of variables are government spending or tax rate. Economic policy may alter this kind of variables to try to archive some goals, like employment rate or GDP.
To estimate the value of an endogenous variable in the future, an economic model can be used. Since human and economic behavior cannot be predicted, a model will fail to be 100% accurate in their predictions. But, since models are simplifications, they will include another kind of deviation caused by the assumptions made.
Some economist says a model should be judged based on their predictive power, and not on their assumptions. Others give more importance to the assumptions, since some false premised can lead to wrong conclusions. The conclusions are logically correct.