Using Economic Modelling Basics to build a simple Political Economic Model (Part 1)

So far, we have discussed numerous economic concepts, each varies in many aspects from the others. Yet, I admit that I have been avoiding two important topics in economics, economic modelling and political economics.

Political economics aside (for now), economic modelling is a pivotal groundwork used to analyse all sorts of economic phenomena. For example, Model like DSGE (Dynamic Stochastic General Equilibrium) is an extremely useful tool that allows analysts and policy makers to view the economy from a broad picture and make decisions accordingly to keep the economy on track. DSGE serves as the basic framework for many of its modified versions used widely by many central banks around the world, including the ECB (European Central Bank), to analyse the economy at macro level. Unfortunately, developing countries normally lack the capital and human resource to build this kind of model. Most would resort to a simple financial model or Cost-Benefit analysis framework that provided limited forecasting and/or explanatory power (more on this later).

On that note, I would like to answer three related questions. First, why do we need economic model? Second, though this article is not about DSGE, what is DSGE anyway? Third, if DSGE is so great, why did it fail to predict the recent GFC (Global Financial Crisis)?


Accounting for complexity using simplicity is the purpose of economic models

The need for economic modelling in analysing the economy lies within the convoluting nature of the economy itself, where many variables interact with one another, where many events happen all at once. It is thus not an easy job to attempt to answer any economic question without robust modelling framework, especially when taking into account the fact that the answer itself depends on where and when the question is posed. This is the exact opposite to what one is taught in class.

To put that in perspective, let’s consider a simple question: “What outcome can we expect from increase in government borrowing?”

Well, basic economics 101 says it will lead to short-term boost in GDP (where GDP = Consumption + Investment + Government’s Spending + Net Export). Simple enough because we know that the government borrows to spend.

But, that would raise interest rate and crowd out (reduce) private investment. Think about it. The more the government borrows, the less loanable fund available for the rest of potential private borrowers. It raises interest rate and thus leads to less private borrowing to fund private investment. Okay, so now we have less investment. This reduces GDP. From here on, it is not clear anymore which direction we are heading. Does GDP increase or decrease?

Wait a minute, rising interest rate would lead to less consumption as well since people now borrow less to finance their consumption (like borrow to buy a new flat-screen). Oh, and don’t forget that higher domestic interest rate would attract foreign capital, and this can lead to more demand for domestic currency ( domestic currency rises in value). The appreciating currency would cause imports to increase and hurt the local businesses. This is a minus point to GDP.

Ah, we are not done yet. It seems if the government borrows to invest in education and public health, this might be a good thing in the long run. It increases the labour productivity of the country as time goes by, and consequently, higher GDP in the future. Okay, now we are taking the temporal (time) component into our consideration as well. This is a plus for GDP. And what if we depend too much on foreign money and suddenly there is a global shock to the economy or natural disaster that results in GDP loss, probably a decade into the future?

Now, after all this, tell me, what do you think is the verdict? Is government borrowing a good thing for the economy? If you are confident enough to say “Yes” or “No”, then you are wrong. The right answer should be “I’m not sure”. You see, whether government borrowing is good or bad for economic growth really depends on the magnitude and persistence of each effect described earlier. It also relies heavily on whether there is any unexpected shock, negative or positive, to the economy. It is also possible that the borrowing might be too small to matter (yield no effect). The economy is a huge interactive network of different agents (firms, consumers, governments, foreign investors, etc); thus, the complexity naturally results in causes and effects system that is too complicated to examine verbally without the aid of mathematical model. So, if anyone (especially politicians) simply says A lead to B in economics, then you have a good reason to doubt them. Ask what model they use? On what assumptions and reference point?

DSGE, in particular, is a model that takes into account of both the dynamic and random component (time and shock) of the economy, hence the name: “Dynamic Stochastic”. It also considers all markets within the economy, hence the last name: “General Equilibrium”. The beauty of DSGE lies in its ability to inform its user of the effects of an economic decision (like the above question) on various facets of the economy. Basically, it captures all the relationship and magnitude of the effects we discussed earlier. DSGE has been very influential in contemporary economics, but remember, it is not the only model out there. There are tonnes of basic models and even more of their mind-numbing variants.

Nonetheless, there is one thing to keep in mind: “Garbage in, Garbage out”. Each model is only as good as its assumptions and data, and this is why DSGE failed to predict the 2008 financial crisis. Though in that case, it is neither the failure of the model or the data, but that of the assumptions. In the second part of the post, we will discuss more about DSGE, its failure, and then use the modelling basics to create our own model to analyse the market of legislation in the political world.

Until then.