Simple economic model.

[scotview]

Is it possible to build a very simple, high level economic model with a few key inputs and outputs.

As an example, in the current PM debate we have Sunak advocating no tax cuts (notwithstanding his U turn on domestic energy VAT) for fear of inflation. Truss recommending tax cuts to put money in peoples pockets now and payback later. Is there is any possibility for a simple model or is it all too political.

Is a best case, simple model just not achievable ? Maybe this question is just too naive.

[Urbandreamer]

Is it possible to build a very simple, high level economic model with a few key inputs and outputs.

As an example, in the current PM debate we have Sunak advocating no tax cuts (notwithstanding his U turn on domestic energy VAT) for fear of inflation. Truss recommending tax cuts to put money in peoples pockets now and payback later. Is there is any possibility for a simple model or is it all too political.

Is a best case, simple model just not achievable ? Maybe this question is just too naive.

It's not naive at all. All you need is a war surplus pump from a bomber, a few water tanks and pipes, some floats that move leavers which in turn open valves.

https://www.youtube.com/watch?v=gkNaZJmii28&t=289s
A nice computer that "run's" the Cambridge equation. Of course the validity of that equation is a matter of some debate.

[GrahamPlatt]

It sounds a bit Pyadic in its mechanical approach, but it would probably do a lot better than a bunch of rich old bankers / politicians sitting in dusty offices in central London.

There, fixed that for you.

[Steveam]

AI “you want full employment?”
Politician “yes”
AI “shoot all the unemployed”
AI “and for good measure we can improve productivity by shooting all the unproductive”
Politician “but that includes me”
AI “indeed”

Best wishes,

Steve

[ursaminortaur]

Is it possible to build a very simple, high level economic model with a few key inputs and outputs.

As an example, in the current PM debate we have Sunak advocating no tax cuts (notwithstanding his U turn on domestic energy VAT) for fear of inflation. Truss recommending tax cuts to put money in peoples pockets now and payback later. Is there is any possibility for a simple model or is it all too political.

Is a best case, simple model just not achievable ? Maybe this question is just too naive.

I've often thought that it just just be left to an AI these days. Just tell it what outcome you want (i.e. full employment or whatever) and let it crunch the numbers on a daily basis. It will then tell you what to adjust or amend. The obligation of the party in power is that it adheres to the machines recommendations.

It sounds a bit Pyadic in its mechanical approach, but it would probably do just as well as bunch of rich old bankers / politicians sitting in dusty offices in central London.

The economy of the UK is connected to the economy of other countries so in such an ideal system you would likely need all world governments to follow the same machine's recommendations.

Unfortunately as referenced in the previous post referring to the Cambridge equation (and asociated Phillips hydraulic analogue computer) economists don't agree what equations to use and the results produced by any of them don't tally with reality closely enough to definitively choose between them. Partly this is down to the fact that the models use non-linear equations and can be chaotic in behaviour producing different results depending upon small changes in initial conditions, ie similar to the weather, and partly because of fundamental disagreements between economists as to how the models should be constructed.

In the end this is probably unsolvable because a fully accurate model would have to take into account not just the statistical behaviour of people buying and selling things but also the impacts of all sorts of historical events (eg that Russia would invade Ukraine, the strength and abilities of the Russian forces, how western governments would react, whether or not and to what extent Russian supply of gas to the EU would blunt that response etc etc). In effect what is being aked for is a version of Hari Seldon's psychohistory from Asimov's foundation scifi series but operating on a small (maybe day to day ) timescale.

[BT63]

Is it possible to build a very simple, high level economic model with a few key inputs and outputs.

No.

Even if it was possible, it wouldn't necessarily give a clue as to the direction of the stock market because stock markets run on greed, fear, momentum and whether something unexpected comes along.

[MDW1954]

Is it possible to build a very simple, high level economic model with a few key inputs and outputs.

As an example, in the current PM debate we have Sunak advocating no tax cuts (notwithstanding his U turn on domestic energy VAT) for fear of inflation. Truss recommending tax cuts to put money in peoples pockets now and payback later. Is there is any possibility for a simple model or is it all too political.

Is a best case, simple model just not achievable ? Maybe this question is just too naive.

The answer is "yes", subject to you having an appropriate background in econometrics. But relatively few people do, and speaking as someone who took econometrics at postgraduate level, I certainly wouldn't feel comfortable doing it. At the very least, I'd want to reduce it to a single multiple regression equation, intended to "predict" the key economic outcome of interest -- presumably GDP, although YMMV.

See:

http://obr.uk/docs/dlm_uploads/Working-paper-No4-A-small-model-of-the-UK-economy.pdf

MDW1954

[scotview]

The answer is "yes", subject to you having an appropriate background in econometrics.

MDW1954

Thank you MDW for your interesting reply. I've had a cursory look through the report and will study it more. I know that a model of the economy is complicated but is an empirical approach possible. For example in the current PM debates inflation, productivity, employment level, tax take and budget come up as the main drivers. As shown in the schematic below.

Is there any way to build an empirical, intuitive model with say 5 or 6 inputs and 2 or 3 outputs ignoring all the other noise.

There is a lot of financial, intellectual and mathematical talent on this board.

Maybe this idea is absurd.

[MDW1954]

The answer is "yes", subject to you having an appropriate background in econometrics.

MDW1954

Maybe this idea is absurd.

I don't think it is absurd, but you need to be clearer about what you are wanting to achieve. Then it would be easier for people to help you.

For instance, in the model shown in your diagram, inflation appears to be the only output. Were I to try and model inflation with a multiple regression equation, I'd certainly include more variables than those you list -- M3 or M4 money, for instance, as well as those variables relating to the specific inflation measure chosen. Something around housing demand, for instance, for CPIH.

Personally, I'd also want to predict something other than inflation, like GDP.

MDW1954

[scotview]

I don't think it is absurd, but you need to be clearer about what you are wanting to achieve.

MDW1954

It's just a bit a thought experiment really. Could we achieve an illustrative/predictive model, at a very high level. If you do this then this happens, doesn't need to be exact.

In the recent PM debates concerning tax, Sunak suggested that reducing tax would push up inflation. Truss said that the bill for reduced tax could be paid in three years time and "inferred" that inflation wasn't a risk. Well, reduced tax will either mean increased inflation or it wont. So plug in a new global, annual tax figure and see what inflation the model shows you.

My graphic was a starting point. I didnt show GDP because it includes stuff like folkies spending in restaurants, or changes due to new money supply. That's not productive in my book but there is maybe a case to show it.

OK, show money supply but as a global number, not M3, M4 etc.

Create a few very high level, integrated, empirical algos and plug them in. OK its all on very high level assumptions but at least it shows input and output and the empirical algos can be tweaked to the consensus view.

BUT, maybe all of the above is just plain rubbish.

[Urbandreamer]

In the end this is probably unsolvable because a fully accurate model would have to take into account not just the statistical behaviour of people buying and selling things but also the impacts of all sorts of historical events (eg that Russia would invade Ukraine......

To be fair the actual war, rather than it's progress, was predicted in the 2015 book "Prisoners of Geography".

I confess that I'm curious as to the purpose of this "simple economic model". Some early work on weather models showed disturbing aspects in even very simple equations. It's covered in an earlier book "Chaos" and is know popularly as the Butterfly effect. Fundamental dependence on initial conditions, which often can not be measured or changed accurately.

The Phillips machine can be accurate using simple equations to about 4%, but that is with well known inputs.

It's questionable how accurate we know the amount of "money" in our economy. For those who have not looked into "money", it's created and destroyed all the time. When a bank lends for a car, or someone buys food with a credit card, money is created. Banks and Visa lend more than they have deposits. When the debt is paid that money is destroyed. The video showed how the machine represented this, but how valuable is that if you don't know the state or are poorly able to adjust the position of the valves that control that? This is often known as the velocity of money as more supply enables more and faster trades, a bit like tap and go at the supermarket or on the train.

The velocity is also impacted by non-bank lenders, LETS (local exchange trading schemes) and other non monitored transactions such as cryptocurrency. What of "mate's rates", charity, food banks or the circular economy?

I seriously question the amount of influence the BOE or government have over the economy, though I hold them accountable simply because they claim responsibility.

Ps, I have no formal education in economics, but can recommend it as a area worthy of study.

[Wuffle]

A casual glance at the buildings occupied by the ECB and the Fed would suggest that a 'Simple economic model' probably won't cut it.

W.

[GoSeigen]

A casual glance at the buildings occupied by the ECB and the Fed would suggest that a 'Simple economic model' probably won't cut it.

W.

Yes, complexity for the sake of complexity. I suspect any kind of simple economic model would be instantly dimissed by those that control our money because it would hurt their money.

Yes they should have sort of simple models you get on bulletin boards like this. 20 years of predicting that falling interest rates and money printing will definitely cause inflation. Then when inflation doesn't show up another twenty years of MMT/"we can print as much money as we like because we have our own currency" while inflation goes nuts!

Easy.


GS

[ursaminortaur]

A casual glance at the buildings occupied by the ECB and the Fed would suggest that a 'Simple economic model' probably won't cut it.

W.

Yes, complexity for the sake of complexity. I suspect any kind of simple economic model would be instantly dimissed by those that control our money because it would hurt their money.

Yes they should have sort of simple models you get on bulletin boards like this. 20 years of predicting that falling interest rates and money printing will definitely cause inflation. Then when inflation doesn't show up another twenty years of MMT/"we can print as much money as we like because we have our own currency" while inflation goes nuts!

Easy.


GS

The problem is that a model of the real world isn't the real world. In a previous post I alluded to the fact that chaotic behaviour can arise from systems involving non-linear equations but there are also other problems. Because the situations are complex simplifying assumptions are made which may hold in certain circumstances but not in others and even with those simplifications exact solutions to the resulting equations might only be possible in limited circumstances, if at all, meaning that numerical approximate solutions have to be found which brings in other assumptions as to the circumstances in which those approximations hold true ie can you really truncate the taylor series that early in these particular circumstances or are later terms in the infinite series significant. And although those who first develop the equations and models may be perfectly aware of these limitations those who use the models frequently forget about them and continue to rely on the predictions when it is clear that the underlying simplifying assumptions are no longer applicable. See for instance the use of the Black-Scholes equation to price European call and put options which was the foundation for the models used for derivative trading prior to and during the financial crash.

https://www.bbc.co.uk/news/magazine-17866646

Black-Scholes: The maths formula linked to the financial crash
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The Black-Scholes formula had passed the market test. But as banks and hedge funds relied more and more on their equations, they became more and more vulnerable to mistakes or over-simplifications in the mathematics.

"The equation is based on the idea that big movements are actually very, very rare. The problem is that real markets have these big changes much more often that this model predicts," says Stewart. "And the other problem is that everyone's following the same mathematical principles, so they're all going to get the same answer."

Now these were known problems. What was not clear was whether the problems were small enough to ignore, or well enough understood to fix. And then in the late 1990s, two remarkable things happened.

"The inventors got the Nobel Prize for Economics," says Stewart. "I would argue they thoroughly deserved to get it."

Fischer Black died young, in 1995. When in 1997 Scholes won the Nobel memorial prize, he shared it not with Black but with Robert Merton, another option-pricing expert.
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"It was abuse of their equation that caused trouble, and I don't think you can blame the inventors of an equation if somebody else comes along and uses it badly," he says.

"And it wasn't just that equation. It was a whole generation of other mathematical models and all sorts of other techniques that followed on its heels. But it was one of the major discoveries that opened the door to all this."

Black-Scholes changed the culture of Wall Street, from a place where people traded based on common sense, experience and intuition, to a place where the computer said yes or no.

But is it really fair to blame Black-Scholes for what followed it? "The Black-Scholes technology has very specific rules and requirements," says Scholes. "That technology attracted or caused investment banks to hire people who had quantitative or mathematical skills. I accept that. They then developed products or technologies of their own."

Not all of those subsequent technologies, says Scholes, were good enough. "[Some] had assumptions that were wrong, or they used data incorrectly to calibrate their models, or people who used [the] models didn't know how to use them."



https://www.ft.com/content/30fc4ece-760b-11e2-9891-00144feabdc0

On October 19 1987, the floor fell out from under world financial markets. The Dow Jones Industrial Average fell 508 points, or almost 23 per cent. “Black Monday”, as it has come to be known, remains the largest single-day market drop in history.

The culprit was a new kind of investment product known as portfolio insurance. Based on a mathematical model for pricing options, portfolio insurance consisted of a strategy of selling stock market index futures short while buying other equities. According to the Black-Scholes model, an event such as Black Monday could not happen. It was so unlikely it should not have occurred in the lifetime of the universe.

After the crash, investors screamed that the maths behind portfolio insurance had failed. And since then, history has repeated itself. After Long Term Capital Management imploded in 1997, the models were to blame. The 2007-08 crisis? Again the models. So, too, with the “London whale” fiasco that cost JPMorgan Chase upward of $6bn last year. The popular response is always the same. As Warren Buffett put it in 2009: “Beware of geeks bearing formulas.”

But criticising the maths is easy. The models are not the problem – it is how we think about models, and how we use them as a result.

The models at the heart of modern finance are often said to be mathematically complex and impossible to understand. But this belies the fact about how they work. It is the world that is mind-bogglingly complex. The models are dramatic simplifications, designed to give some small quantitative purchase on problems that would otherwise be intractable.
To achieve these simplifications, model builders make assumptions about how the world works – assumptions that rarely hold exactly and often fail spectacularly.

But this should not militate against using models as a central part of financial decision-making so much as sharpen our focus on just what assumptions our models make, and how those assumptions can and will fail.


https://en.wikipedia.org/wiki/Black%E2%80%93Scholes_equation

Once the Black–Scholes PDE, with boundary and terminal conditions, is derived for a derivative, the PDE can be solved numerically using standard methods of numerical analysis, such as a type of finite difference method.[3] In certain cases, it is possible to solve for an exact formula, such as in the case of a European call, which was done by Black and Scholes.

https://en.wikipedia.org/wiki/Finite_difference_method

In numerical analysis, finite-difference methods (FDM) are a class of numerical techniques for solving differential equations by approximating derivatives with finite differences.
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Finite difference methods convert ordinary differential equations (ODE) or partial differential equations (PDE), which may be nonlinear, into a system of linear equations that can be solved by matrix algebra techniques. Modern computers can perform these linear algebra computations efficiently which, along with their relative ease of implementation, has led to the widespread use of FDM in modern numerical analysis.[1] Today, FDM are one of the most common approaches to the numerical solution of PDE, along with finite element methods.

Derivation from Taylor's polynomial

First, assuming the function whose derivatives are to be approximated is properly behaved, by Taylor's theorem, we can create a Taylor series expansion
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[vand]

The answer is "yes", subject to you having an appropriate background in econometrics.

MDW1954

Thank you MDW for your interesting reply. I've had a cursory look through the report and will study it more. I know that a model of the economy is complicated but is an empirical approach possible. For example in the current PM debates inflation, productivity, employment level, tax take and budget come up as the main drivers. As shown in the schematic below.

Is there any way to build an empirical, intuitive model with say 5 or 6 inputs and 2 or 3 outputs ignoring all the other noise.

There is a lot of financial, intellectual and mathematical talent on this board.

Maybe this idea is absurd.

Yes, it's absurd... sorry. Trying to reduce a system as complex as the macro economy down to a simple diagram is like trying to explain the complexities of the human body using using a flowchart. You can explain basics of how it works "food + nutirents in -> biochemistry happens -> waste comes out" but we know that's just a gross simplification and wouldn't be able to diagnose you when there is a medical problem.

The macro economy is - or should be - market forces setting billions of price points, not just of goods and services, but of assets and of money itself. The outcome is that over time, capital ends up allocated in the most productive places, maximizing output for the finite inputs available at hand.

[spasmodicus]

Yes, it's absurd... sorry. Trying to reduce a system as complex as the macro economy down to a simple diagram is like trying to explain the complexities of the human body using using a flowchart.

Hear hear! And remember Niels Bohr who said "Prediction is very difficult, especially if it’s about the future!"

Instead of wasting time trying to model these things, you might try a different approach, like relying on an expert e.g. someone like Liz Truss, who read PPE at Oxford, to do the prediction for you. Incidentally when I was at said institution, I concluded that it was all the thickos that did PPE, whereas smartarses like me read Natural Sciences. However, from a career development point of view she probably made the better choice, as reading PPE is highly predictive for one's chances of becoming prime minister. Rishi read PPE at Oxford too, but on the other hand, Maggie Thatcher read Chemistry at Oxford, so the degree studied parameter is not reliable. In fact neither PPE nor Chemistry seem to confer useful skills at running an economy. So why not appoint someone to do it for you, e.g. Andrew Baily of the Bank of England, who read History at Cambridge? Not much joy, or predictive capability there either, it seems. But he has a monetary policy comittee to do it for him, comprising members with degrees from all sorts of prestigious universities. So hiring a bunch of experts to do the "simple" job of predicting inflation obviously didn't work either.

For the time being, I will stick with the simple predictor "printing money causes inflation".

S

[scotview]

For the time being, I will stick with the simple predictor "printing money causes inflation".

S

Now that's what I'm talkin' about !

[vand]

I have found the best way to consider this is the "island economy" that is sometimes used by Austrians to illustrate behaviour. Instead of starting from a top down level by abstracting today's real economy down into oversimplified macro aggregates, you start from the bottom up, and ask how a group of islanders build and sustain their own economy, grow it and how it can be affected by dictate.

Instead of talking about things like interest rates, inflation, unemployment etc you are describing the economy in terms of real goods and services - number of fish caught, berries picked, jumpers knitted etc.

Look on Youtube for "How and economy grows and why it doesn't"
or read Henry Hazlitt's "Economics in one Lesson"

People will say that these texts are far too simple to explain the complexity of the economy today -- but that is beside the point. They're not trying to explain every nuance of the economy, they're trying to teach you economics, the social science of how best to allocate finite resources to satisfy unlimited wants.

Austrians and their ilk use deductive reasoning as the basis of their models, rather than empirical observation and econometrics used by today's Keynesians and monetariests which, at best, can only tell us correlation and never causation.

[dealtn]

Austrians and their ilk use deductive reasoning as the basis of their models, rather than empirical observation and econometrics used by today's Keynesians and monetariests which, at best, can only tell us correlation and never causation.

I think you will find the vast majority of the profession disagreeing with you regarding correlation and causation. Most will know the difference and do predict and measure causation in their models. Even macroeconomists understand microeconomics.

[scotview]

OK, so let's break down the economy into bite sized chunks. Consider inflation.

Inflation % = (Original Cost - New Cost) / Original Cost * 100

The main reason for inflation recently has been energy costs, not money printing, not wages. So take a typical home:

Original Monthly household Cost = £1000 say 12 months ago (this can be multiplied by 20 million if you like big numbers)
New Monthly household Cost = £1100 (energy increase)

So inflation = 10% is it not as simple as that ?

Looks like the model needs an input arrow called "household costs". Is it impossible to build a ready reckoner based on this level of simplicity ? Lots of clever guys out there........