Economic model

However, properly constructed models can remove extraneous information and isolate useful approximations of key relationships.

The diagnostic step is important because a model is only useful to the extent that it accurately mirrors the relationships that it purports to describe.

At a more practical level, quantitative modelling is applied to many areas of economics and several methodologies have evolved more or less independently of each other.

All through the 18th century (that is, well before the founding of modern political economy, conventionally marked by Adam Smith's 1776 Wealth of Nations), simple probabilistic models were used to understand the economics of insurance.

Modern policy makers tend to use a less activist approach, explicitly because they lack confidence that their models will actually predict where the economy is going, or the effect of any shock upon it.

This is because complex systems like the economy or the climate consist of a delicate balance of opposing forces, so a slight imbalance in their representation has big effects.

Thus, predictions of things like economic recessions are still highly inaccurate, despite the use of enormous models running on fast computers.

Although the modern mathematical work on chaotic systems began in the 1970s the danger of chaos had been identified and defined in Econometrica as early as 1958: It is straightforward to design economic models susceptible to butterfly effects of initial-condition sensitivity.

[citation needed] This would mean that refinements to the models could ultimately produce reliable long-term forecasts.

However, the validity of this conclusion has generated two challenges: More recently, chaos (or the butterfly effect) has been identified as less significant than previously thought to explain prediction errors.

One reason, emphasized by Friedrich Hayek, is the claim that many of the true forces shaping the economy can never be captured in a single plan.

This is an argument that cannot be made through a conventional (mathematical) economic model because it says that there are critical systemic-elements that will always be omitted from any top-down analysis of the economy.