Question

3.

Discuss the validity of the following statement “Economic models play an important role when it comes to developing sound economic policies.”

Answer 1

Economic models are extremely crucial when it comes to developing sound economic policies. There is a famous saying which goes as follows, 'All models are wrong. But some are useful.' This means that models should not be seen as an exact replication of the real world. They are based on assumptions (sometimes indeed unrealistic) which are subject to change. The correct way to see a model is that it represents the real world in the simplest form. If certain conditions hold true, economic models can predict with a great degree of accuracy the changes in the real world. Indeed, most of the historic economic policy has been based on some models. Most of the post war (II) policy in US and Europe was based on The Keynesian aggregate demand.model. Almost all the central banks presently use some form of the Taylor rule ( a monetary model) for setting the policy rates. Without a good model, it is very difficult to identify the causal links between different variables as mere empirical analysis might confound correlations with causation. Identifying the difference is crucial for policymaking as we get a better understanding of what variables to target. Models are used in all spheres of economic policy to carry out alternative situation simulations which help in understanding what can happen to the economy if we change the initial conditions slightly. Even as we fight the current COVID-19 pandemic, most of the economic policy decisions are backed by some models with a set of predictable outcomes.