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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 specific questions-such as the implications of asymmetric information (when one side to a transaction knows more than the other) or...