HANDOUT 4: ECONOMIC MODELS

Definitions:

An economic model is an abstract simplified mathematical (algebraic and/or graphical) representation of relationship between economic variables.

An endogenous variable (dependent variable) is a variable whose value is determined within the model.

An exogenous variable (independent variable) is a variable whose value is determined outside the model.

A parameter shows the strength of a relationship between two variables. Parameters are usually assumed to be constant.

Models are constructed from assumptions, variables (both types) with or without parameters, and logical analysis via algebra, calculus and/or graphs.

Assumptions are used to simplify the vast complexity of economic behavior down to analyzable units; they limit the scope of analysis. In so doing, they specify which variables are endogenous and exogenous and which are not even relevant. They may or may not specify the size or strength of various parameters, depending on the situation.

Assumptions set the constraints on and initial conditions of analysis for the model. They are used to construct logical relations among the model's variables, via equations and/or graphs. In this context, values of exogenous variables, initially taken as given, are placed into the model and then it is solved for the values of the endogenous variables. The exogenous values may then be changed "experimentally" to see how they influence the endogenous variables.

Can you think of examples of models in what you have seen so far in the text?

The experimental adjustment of exogenous variables is then used to formulate hypotheses for testing and to make predictions (based on these hypotheses) about the behavior of specific economic variables.

What do you think about the strengths and weaknesses of this form of analysis?

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