Differentiate between Structural Form Equations and Reduced Form Equations.

Structural Form Equations vs. Reduced Form Equations

Structural Form Equations:

1. Definition: Structural form equations represent the underlying economic relationships between variables in a theoretical model. They express how endogenous variables are determined by exogenous variables and other endogenous variables in the system.

2. Characteristics:

   • They are based on economic theory and represent causal relationships.
   • They often include error terms to account for unobservable factors and measurement error.
   • They provide insights into the mechanisms driving the system and the effects of policy interventions.

3. Example: In a simple Keynesian model, the consumption function could be a structural form equation expressing how consumption is determined by income and other factors.

Reduced Form Equations:

1. Definition: Reduced form equations are derived from structural form equations by solving for endogenous variables in terms of exogenous variables. They represent the observed relationships between variables without explicitly modeling the underlying economic mechanisms.

2. Characteristics:

   • They do not represent causal relationships but rather statistical associations.
   • They may not include error terms if the structural errors are not needed for the analysis.
   • They are useful for estimating the effects of changes in exogenous variables on endogenous variables.

3. Example: In the same Keynesian model, the reduced form equation for consumption could express how consumption changes in response to changes in income, without specifying the underlying reasons for this relationship.

Key Differences:

1. Nature of Relationship: Structural form equations represent causal relationships based on economic theory, while reduced form equations represent statistical relationships observed in the data.

2. Endogeneity: Structural form equations explicitly model endogeneity, while reduced form equations treat endogenous variables as determined solely by exogenous variables.

3. Usefulness: Structural form equations are useful for understanding the economic mechanisms at work and for policy analysis, while reduced form equations are useful for empirical estimation and prediction.

4. Example: In a supply and demand model, the structural form equations would represent how supply and demand are determined by factors such as price and income, while the reduced form equations would show how quantity and price are related without explicitly modeling supply and demand.

In conclusion, structural form equations and reduced form equations represent different ways of modeling relationships between variables, with structural form focusing on underlying causal mechanisms and reduced form focusing on observed statistical associations.