Theoretical frameworks of economics: Models that simplify the complex

What you need to know

• Economic models break down complex economic phenomena into analyzable elements, facilitating the prediction of variables such as inflation and unemployment.
• Although they do not directly apply to cryptocurrency markets, they provide valuable conceptual tools for interpreting crypto metrics and dynamics.
• Governments and companies use these frameworks to formulate more accurate policies and business strategies based on economic projections.

Understanding how economic models work

The economy presents an inherent complexity due to the multiplicity of interconnected variables that make it up. To tackle this challenge, economists have devised methods that break down economic reality into more manageable and studyable components. This article examines in depth what these theoretical frameworks are, their constitutive elements, their variants, their operating mechanics, their relevance in the crypto space, and their practical applications.

Definition and Purpose of Economic Models

Economic models are simplified constructions that represent actual economic processes and dynamics. They serve as tools that allow economists and authorities to understand the interactions between different components of the economic system, such as inflation and unemployment levels.

These frameworks serve three essential functions:

1. They reveal the causal connections between different economic variables.
2. They enable predictions about upcoming economic trends and events
3. They enable the assessment of potential impact before implementing economic policy measures.

Constitutive elements of economic models

Economic variables

The variables represent magnitudes that fluctuate and condition the results of the model. Among the most relevant, we find:

1. Price: the monetary amount required to acquire a good or service
2. Amount: the volume of goods or services generated or consumed
3. Income: the cash flows received by individuals or families
4. Interest rates: the cost associated with borrowing

Parameters and constants

Parameters function as invariant values that determine how variables behave within the system. In a framework that analyzes the nexus between inflation and unemployment, these may include the natural rate of unemployment (NRU) and the degree of inflation sensitivity to variations in unemployment. The NRU—also referred to as NAIRU (the unemployment rate that does not accelerate inflation)—corresponds to the level of unemployment that prevails when there is equilibrium in the labor market.

Mathematical expressions

Equations constitute the mathematical foundation of any economic model, expressing the relationships between variables and parameters. A paradigmatic example is the Phillips curve, which articulates the relationship between inflation and unemployment through the following expression:

• π = πe ​− β (u−un​)

Where:

• π = inflation rate
• πe = expected inflation rate
• ß = sensitivity of inflation to changes in unemployment
• u = observed unemployment rate
• un = natural rate of unemployment

Simplifying Assumptions

Assumptions act as constraints that make the models more tractable. The most common include:

1. Economic rationality: consumers and businesses make decisions aimed at maximizing profit or satisfaction.
2. Competitive markets: there are multiple buyers and sellers, with none able to dominate the price dynamics.
3. Ceteris paribus: other factors remain constant while examining the effect of a specific variable.

Construction and Operation Mechanism

Phase 1: Identification of central variables and their relationships

The first step is to determine which variables will be relevant and how they interconnect. In a supply and demand model, the primary variables are:

• Price (P)
• Quantity demanded (Qd)
• Offered amount (Qs)

Relationships are expressed through curves that illustrate how Qd and Qs vary in response to changes in P.

Phase 2: Parameter Estimation

Empirical data is collected to quantify the parameters. In this context, the following stand out:

• Price elasticity of demand: reflects how much Qd changes in response to movements in P
• Price elasticity of supply: reflects how much Qs changes in response to movements in P

Phase 3: Formulation of equations

Algebraic expressions are developed that capture the identified relationships. For example:

• Qd = aP ( where a is the price elasticity of demand)
• Qs = bP ( where b is the price elasticity of supply)

Phase 4: Establishment of assumptions

The conditions that define the scope of the model are specified, clarifying which factors are included and which are excluded. A typical supply and demand model assumes:

• Perfect competition: focus on the fundamental mechanics, disregarding market frictions
• Ceteris paribus: isolation of the effects of P on Qd and Qs

Illustrative case: Apple market

Let's consider an apple market to demonstrate how economic models operate.

Step 1: Variables and relationships

Main variables:

• Price (P): the market value of apples
• Demand Quantity (Qd): volume that consumers wish to purchase at each price
• Offered quantity (Qs): volume that producers wish to sell at each price

The curves illustrate how both quantities respond to changes in price.

Step 2: Parameter Estimation

Suppose:

• Price elasticity of demand = -50
• Price elasticity of supply = 100

This implies:

• Each increase of 1 USD in price reduces Qd by 50 units
• Each increase of 1 USD in price increases Qs by 100 units

Step 3: Development of equations

• Qd = 200 − 50P
• Qs = -50 + 100P

Step 4: Assumptions

• Perfect competition: multiple participants, none with market power
• Ceteris paribus: other factors remain unchanged

Step 5: Balance Calculation

We equate Qd = Qs:

200 − 50P = -50 + 100P 250 = 150P P = 1.67 USD

Substituting into either of the equations:

Qd = 200 − (50 × 1.67) = 116.5 Qs = 117 units

Step 6: Interpretation

The equilibrium price is approximately 1.67 USD with an equilibrium quantity close to 117 units. This point maximizes efficiency:

• If P > 1.67 USD: excess supply
• If P < 1.67 USD: excess demand

Classification of Economic Models

Visual representations

These frameworks use diagrams and graphs to visualize economic concepts. They make abstract concepts like supply and demand curves more accessible and understandable through graphical representations.

Models based on empirical data

They rely on real-world information to contrast theories and quantify relationships between variables. They start with theoretical equations and then use observed data to estimate parameters. For example, they can quantify how national investment changes when the interest rate increases by 1%.

Formal mathematical frameworks

They use algebraic expressions to formalize theories and economic links. They require mastery of calculus and algebra and can be highly sophisticated. A simple example would include equations for supply, demand, and the equilibrium point.

Models with Rational Expectations

They incorporate the predictions that economic agents make about the future, improving predictive capacity regarding variables such as inflation or interest rates. They recognize that if agents expect higher future inflation, they may increase present spending, raising immediate demand.

Computational simulations

They use software programs to recreate real economic scenarios. They allow experimentation with multiple variables and observation of outcomes without the need for real-world testing. They are particularly useful for analyzing potential consequences of policies or economic crises.

Static vs Dynamic Models

Static models capture a snapshot of the economy at a given moment, being simpler but ignoring temporary changes. A static supply and demand model shows equilibrium without considering how the market readjusts in response to disturbances.

In contrast, dynamic models incorporate time as a dimension, showing how variables evolve. Although more complex, they provide a superior understanding of cycles and long-term trends, illustrating how economic conditions transform in response to external shocks or policy changes.

Applicability in the cryptocurrency sector

Price and supply-demand dynamics

Economic models illuminate how the supply (amount of available tokens) and the demand (interest of buyers) determine cryptocurrency quotes. By analyzing these components, we can anticipate price movements and emerging market trends.

Transaction cost impact

Cost analysis frameworks reveal how fees in blockchain networks affect user behavior. High fees discourage activity, while low fees stimulate it. This analysis allows us to foresee how changes in costs influence adoption and network efficiency.

Prospective scenarios through simulation

Simulations allow the creation of virtual environments to explore the impacts of various variables in crypto markets. They can model regulatory changes, technological advancements, or modifications in user preferences. Although theoretical, they provide analytical frameworks to anticipate possible developments.

Inherent Limitations

Assumptions far removed from reality

Many economic models rest on assumptions that reality often violates. They may assume perfect competition or rational behavior, attributes not always present in real markets. This reduces their accuracy when applied to concrete phenomena.

Over-simplification

Although necessary for tractable analysis, simplification can omit significant factors, generating results that do not fully capture the true economic complexity. For example, a model might assume consumer homogeneity and ignore relevant individual differences.

Practical Applications

Policy Evaluation

Governments use these frameworks to project the impacts of alternative policies—tax reductions, increases in public spending, changes in interest rates—allowing for more informed decisions and more effective policies.

Projections and planning

The models enable forecasts of future economic trends—growth rates, unemployment, inflation—helping businesses and governments to plan strategically.

Business strategy

Companies use these frameworks to align strategies with expected economic conditions. They can project product demand and calibrate production levels accordingly.

Featured economic models

Supply and Demand

This fundamental model shows how price and quantity are determined in markets. The supply curve expresses how much producers will sell at each price; the demand curve expresses how much consumers will buy. Their intersection defines market equilibrium.

IS-LM Model

Articulates the relationship between interest rates and real output. The IS curve represents equilibrium in goods markets; the LM curve represents equilibrium in money markets. Their intersection indicates the simultaneous equilibrium of both markets.

Phillips Curve

It illustrates the link between inflation and unemployment, suggesting that higher inflations correlate with lower unemployment rates. It helps authorities understand the trade-offs between inflation control and employment management.

Solow Growth Model

Examine long-term economic growth considering labor, capital accumulation, and technological progress. Identify how these factors lead to steady-state growth.

Final reflections

Economic models act as lenses that clarify economic reality, breaking down intricate dynamics into comprehensible components. They reveal how different variables interact to produce economic outcomes. Government authorities and businesses rely on them to make informed decisions. In the crypto context, these frameworks provide conceptual tools to analyze market dynamics, impacts of transaction costs, and potential future scenarios, facilitating understanding of how multiple factors can influence cryptocurrency markets.