How do economists validate the predictions of their models?

Economists validate the predictions of their models by comparing them with real-world data and adjusting them accordingly.

Economic models are theoretical constructs that represent economic processes by a set of variables and a set of logical and/or quantitative relationships between them. These models are used to predict and explain economic behaviour. However, the real test of any model is how well it can predict future events or explain past events. This is where validation comes in.

Economists validate their models by comparing the predictions of the model with actual real-world data. This is often done by using statistical techniques to analyse the relationship between the variables in the model and the data. If the model's predictions closely match the data, then the model is considered to be valid. However, if there is a significant discrepancy between the model's predictions and the data, then the model may need to be adjusted or rejected.

One common method of validation is backtesting, where the model's predictions are compared with historical data. If the model can accurately predict past events, then it is assumed that it will be able to predict future events as well. However, backtesting has its limitations, as it assumes that the future will behave like the past, which is not always the case.

Another method of validation is cross-validation, where the data is divided into two sets: a training set and a test set. The model is calibrated using the training set, and then its predictions are tested against the test set. This helps to prevent overfitting, where the model is too closely tailored to the training data and performs poorly on new data.

Economists also validate their models by subjecting them to peer review. Other economists will scrutinise the model, its assumptions, and its predictions, and provide feedback. This helps to ensure that the model is robust and reliable.

In conclusion, validation is a crucial part of the process of developing and using economic models. It ensures that the models are accurate, reliable, and useful for predicting and explaining economic behaviour.