Building Models and Understanding Macroeconomics

Building Models:

The American economy is complex: 130 million workers, 90 million households and 10 million firms all producing $8.5 trillion worth of merchandise and services per year. Economists have placed the intellectual bet that the best way to comprehend this complexity is to simplify. Limit the problem to a very few behavioural relationships ‘cause and effect’ links between 2 sets of economic quantities. Look at merely a small amount of equilibrium conditions, conditions that should be satisfied for economic activity to remain stable. Capture these few behavioural relationships and equilibrium conditions in general algebraic equations (and apply diagrams to symbolize those equations). See how the mathematical system made up of those equations performs. Then apply them back to the real world, and expect to quantifying and simplifying haven’t made the model a bad estimate to reality. Economists call this method of concentration and analysis "building a model."

Simplification is essence of model-building. Economists employ simple models for two reasons. First reason is, no one in fact understands excessively difficult models, and model is of little use if economists can’t figure out the logic behind a model's estimation. And the second reason is, the estimations produced by simple models are almost as good as the ones produced by more complicated models. While the economic models used by “Federal Reserve or the Congressional Budget Office” are more complex than models presented in this textbook, at bottom they are simple cousins of the models used here.

You must have heard that, “economics is more of an art than science.” This signifies that rules for efficient and ‘helpful model building’ for skipping unnecessary detail and complexity while retaining necessary and significant relationships, are nowhere written down. In this significant respect, economists be likely to learn by doing or by example. But there are basic steps which roughly every successful construction of a macroeconomic model follows. They comprises the use of the representative agents, a focus on opportunity costs in figuring out agents' decisions, and watchful attention to the consequence of people's expectations on events.

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