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.
How economists try to simulate reality?
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).
Interpreting reality
An economic model is a simplified description of reality, designed to yield hypotheses about
economic behavior that can be tested. An important feature of an economic model is that it
is necessarily subjective in design because there are no objective measures of economic
outcomes. Different economists will make different judgments about what is needed to
explain their interpretations of reality.
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). They provide qualitative answers to
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