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What is an economic model?

A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 13 Jul 2023

An economic model is a simplified representation of economic reality. It is a tool that economists use to understand how the economy works and to make predictions about how it will behave in the future. Economic models are often based on mathematical equations, but they can also be based on graphical representations or verbal descriptions.

Economic models are constructed using assumptions, variables, and mathematical or logical frameworks to provide insights into how various factors interact and influence economic outcomes. These models can help economists predict, explain, and evaluate the effects of different policies or changes in economic conditions.

Here are some examples of well-known macro-economic models and what they aim to show:

  1. The Solow-Swan Growth Model: This model aims to explain long-term economic growth by considering factors such as capital accumulation, technological progress, and population growth. It shows how changes in these variables can affect a country's output and income levels over time.
  2. The Phillips Curve: The Phillips Curve depicts the inverse relationship between unemployment and inflation. It suggests that as unemployment decreases, inflation tends to increase, and vice versa. This model highlights the trade-off between these two variables and helps policymakers understand the potential consequences of pursuing low levels of unemployment or low inflation rates.
  3. The Mundell-Fleming Model: This model combines elements of international economics and macroeconomics to analyze the effects of fiscal and monetary policies on a small open economy. It explores the interactions between interest rates, exchange rates, and capital flows to understand how policy decisions can impact variables such as output, inflation, and the balance of trade.
  4. The Heckscher-Ohlin Model: This model examines international trade patterns based on differences in factor endowments, specifically capital and labor. It aims to explain why countries specialize in the production and export of goods that intensively use their abundant factors of production. The model provides insights into the gains from
  5. The Rational Expectations Model is a model that assumes that economic agents have perfect information and that they use this information to make optimal decisions.

Economic models are not perfect representations of reality. They are simplifications that are designed to make the economy easier to understand. However, they can be very useful tools for understanding how the economy works and for making predictions about how it will behave in the future.

The purpose of economic models is to simplify the economy and make it easier to understand. They do this by making assumptions about how the economy works. These assumptions are often unrealistic, but they allow economists to make predictions about how the economy will behave.

Economic models are often used to make policy decisions. For example, the government may use a model to predict the effects of a tax cut on the economy. The model can help the government to decide whether or not a tax cut is the right policy to pursue.

The Keynesian Economic Model

Keynesian economics is a macroeconomic theory that emphasizes the role of aggregate demand in determining economic output. It was developed by John Maynard Keynes in the 1930s, in response to the Great Depression.

Keynesian economics argues that the economy can be in equilibrium at less than full employment, and that government intervention is necessary to stabilize the economy and promote economic growth.

The Keynesian model is based on the following assumptions:

  • Aggregate demand: Aggregate demand is the total demand for goods and services in the economy. It is determined by consumption, investment, government spending, and net exports.
  • Aggregate supply: Aggregate supply is the total amount of goods and services that businesses are willing to produce at different price levels.
  • Involuntary unemployment: Involuntary unemployment occurs when people are willing and able to work, but they cannot find a job.
  • Multiplier effect: The multiplier effect is the idea that an increase in spending can lead to a larger increase in output.

The Keynesian model argues that the government can use fiscal policy to stabilize the economy. Fiscal policy refers to government spending and taxation. Keynesian economists argue that the government can use fiscal policy to increase aggregate demand and promote economic growth.

For example, the government can increase spending on infrastructure or provide tax cuts to businesses and consumers. These policies can increase aggregate demand and lead to higher output and employment.

The Keynesian model has been criticized for being too simplistic and for underestimating the role of the private sector in the economy. However, it remains an important framework for understanding how the economy works and for making policy decisions.

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