Reading: Lesson 3 - Between News and Policy: The Framework of Macroeconomics

1. We have seen the news and policy in action. But there is a vital piece missing: given the economic news, how do policymakers know what to do? The answer to this question is at the heart of this book. The basic methodology of macroeconomics is displayed in the Figure below "Macroeconomics Methodology". Macroeconomics involves the interplay of theory, data, and policy. 
   

   
   

2. The answer to the question “how do policymakers know what to do?” is on the top left of the Figure below "Macroeconomics Methodology" theory. Macroeconomists typically begin by observing the world and then try to develop a theoretical framework to explain what they have seen. (An old joke says that the definition of an economist is “someone who sees something happen in practice and wonders whether on earth it is possible in theory.”) Usually, a theory developed by economists has a mathematical foundation—expressed by either equations or diagrams. There is even a bit of art here: the theoretical framework must be simple enough to work with yet realistic enough to be useful. We hinted at these theories in our earlier discussion when we explained that both monetary policy and fiscal policy affect the economy by changing the willingness of households and firms to purchase goods and services. In our applications chapters, we develop these ideas and explain the frameworks that policymakers use when deciding on their policies.

3. Our frameworks—or models, as they are often called—are tested by their ability to match existing data and provide accurate predictions about new data. Models are constantly refined so that they can do a better job of matching facts. After many rounds of interaction between theory and data, a useful framework emerges. This then becomes the basis for policy making. How do policymakers know about the theories devised by economists? Politicians are typically not expert economists. In most countries, a large number of trained economists are employed as advisers to the government. These individuals have studied economic theory and are also familiar with economic statistics, allowing them to provide the link between the economic frameworks and the actual implementation of policy.

4. The big challenge for economists is to understand the links from policy to the aggregate economy. When you first learned to drive, you were presumably introduced to all the instruments in the car: the steering wheel, the accelerator, the brake, the mirrors, and so forth. At the same time, you were learning the rules of the road. For many, the instruments of the car are easy enough to grasp, and the rules of the road are reasonably intuitive. The difficulty (and this is why driving schools make money) is in making the connection between the controls in the car and the outcome you wish to achieve while driving. The same is true of economic modeling: policy tools are not very difficult to understand, yet it can take decades of experience to truly understand how to use these tools effectively.
   

Read article: Bernanke's Models, and Their Limits

Key Takeaway's

• The methodology of macroeconomics involves the interplay between data and models.
• Abstract models provide policymakers with a framework to understand what is happening in the macroeconomy and also a way to predict the effects of policy actions.