Econometric Modeling and Model Falsification

A recent literature on qualitative analysis has shown that its successful application in testing the consistency of the sign patterns of a proposed structure and an estimated reduced form was far less restricted than a previous literature had proposed. A frequent example used in this demonstration was the qualitative analysis of Klein’s Model I. For this, the proposed structural sign pattern was falsified by the sign pattern of the estimated reduced form. As a result, the subsequent application two-stage least squares would always find quantifications of the structure that could not possibly have resulted in the sign pattern of the estimated reduced form. We view this result as a diagnostic calling for further analysis. We show that the Klein model fails standard over identification tests. We make modest amendments to the model that resolves this problem but find that the resulting estimated reduced form still falsifies the structure, calling for further developmental effort. Our point is that qualitative falsification should be viewed as a diagnostic in developing a model, rather than a criterion for entirely dismissing the model.