Thursday, July 29, 2010

Mathematical Modeling is an Art!

The Economist has an article challenging the use of dynamic, stochastic equilibrium models of the economy for economic forecasting and policy analysis. The point is not that such models are not useful, or even that they have been stretched from their original academic purposes for use in economic policy making, but that a variety of model types should be used to develop a more complete understanding of the economy. The article cites a recent Congressional hearing on the topic.

Any mathematical model is at best a representation of reality. There is always a trade-off between the complexity of the model and the cost of model development and data collection versus the verisimilitude of the model's results, a trade off which should be made on the basis of the uses intended for the model. Indeed, there is always a question of whether to use one or several models.

The idea that the economy is in equilibrium has been very powerful, and equilibrium models are often useful. On the other hand, they tend to fail when the economy is not in equilibrium, as is the case when there is an economic bubble and especially when the bubble bursts.

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