Requirements on models

An economic system:
  • Has feedback loops
  • Consists of different sectors and economic actors
  • Is made up of different layers
  • Is dynamic

Models of economic systems should be able to deal with these phenomena. There are other characteristics that can be treated, e.g. different categories in the same sector (age groups, income, etc.).

The structure is shown in simplified form in the figure above. It shows three sectors: the public sector, households and the private sector (companies). The top layer shows how payment flows between sectors, the lowest layer shows the flows of labor, goods and services. The vertical dashed lines show the price relationships, left the price of labor (salary / worked man-year) and to the right the price of goods and services (price / produced man-year). I define a produced man-year as the amount of goods and services produced with an input of one worked man-year at a productivity factor = 1. If productivity increases, more goods are produced with the same amount of work or working hours are reduced for the same amount of products.

The feedback is that work will impact the amount of goods and services, or vice versa, and that the wage bill (arrows left) determines the purchasing power and tax capacity (the arrows to the right).

Dynamic effects occur when part of the production is used to increase the volume of production or when the money is saved or borrowed (banks are not shown in the figure). This creates automatic interest payments and amortization.

Other more subtle effects are changing consumption or investment. They may be considered as input to the model (exogenous variables). The flows that are determined within the model are endogenous variables.

Warning: A model should be used carefully and with judgement. Do not try to force reality into the constraints of a model. The Procrustes effect (e.g. economic theories)