Economic model dating
This chain of events, as shown by the activities numbered 1–5 in Figure 1, is a description—or diagrammatic model—of the operation of a private-enterprise economy. There is no central bank supplying money, no banking system, and no government levying taxes, building roads, or providing total annual spending on clothing and shoes, subtract 0 billion, and then calculate the balance—annual spending on clothing and shoes beyond the first 0 billion—as a percentage of household income.The column headed “Total − 100” in Table 1 shows the result—a very satisfactory result, with little annual variation around the average of 2.65 percent and no apparent trend over time. Therefore, the value 0 billion represents, in round numbers, 0 per person (0 billion divided by 277.6 million persons).Most econometric forecasters believe that economic judgment can and should be used not only to determine values for exogenous variables (an obvious requirement), but also to reduce the likely size of model error.
The need for the econometrician to use the best available economic judgment about “outside” factors is inherent in economic forecasting.The economic forecaster must be prepared to be wrong because of unpredictable model error. Suppose the forecaster reads reports that indicate unusually favorable consumer reaction to the latest styles in clothing.Suppose, on this basis, the forecaster believes that next year’s clothing purchases are likely to exceed the usual minimum by something closer to 3 percent than to the usual 2.65 percent of household income.Households, using the earnings derived from their labor services, become the customers who purchase the output.The products the businesses produce wind up in the households, and the wage and salary payments return to the businesses in exchange for the products the households purchase.