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Financial and Economic Modeling

What Are Economic Models?

THE MODERN ECONOMY is a complex machine. Its job is to allocate limited resources and distribute output among a large number of agents—mainly individuals, firms, and governments—allowing for the possibility that each agent’s action can directly (or indirectly) affect other agents’ actions.

Adam Smith labeled the machine the “invisible hand.” In The Wealth of Nations, published in 1776, Smith, widely considered the father of economics, emphasized the economy’s self-regulating nature—that agents independently seeking their own gain may produce the best overall result for society as well. Today’s economists build models—road maps of reality, if you will—to enhance our understanding of the invisible hand.

As economies allocate goods and services, they emit measurable signals that suggest there is order driving the complexity. For example, the annual output of advanced economies oscillates around an upward trend. There also seems to be a negative relationship between inflation and the rate of unemployment in the short term. At the other extreme, equity prices seem to be stubbornly unpredictable.

Economists call such empirical regularities “stylized facts.” Given the complexity of the economy, each stylized fact is a pleasant surprise that invites a formal explanation. Learning more about the process that generates these stylized facts should help economists and policymakers understand the inner workings of the economy. They may then be able to use this knowledge to nudge the economy toward a more desired outcome (for example, avoiding a global financial crisis).