Contents

Introduction...........................................................................................................................................2
Objectives of the Study..........................................................................................................................3
Chapter 1. A Road Map to an Agent–Based Computational Macro Model...........................................6
What is Agent–Based Computational Macroeconomics?..................................................................7
1.1.1 Conceptual Building Blocks...................................................................................................8
1.1.2 Objectives.............................................................................................................................9
1.1.3 Ingredients..........................................................................................................................10
1.2 Virtues of Agent–Based Computational Macroeconomics........................................................12
1.3 Validation Framework...............................................................................................................13
1.3.1 Conceptual Model...............................................................................................................14
1.3.2 Face Validation...................................................................................................................14
1.3.3 Sensitivity Analysis..............................................................................................................14
1.4 Conclusion.................................................................................................................................14
2.1 Overview The structure of the economy of Agent Island is straightforward.............................15
2.1.1 Theoretical Roots and Antecedents....................................................................................15
2.1.2 Markets, Transactions and Financing Contracts.................................................................15
2.2 Model of Agent Island................................................................................................................15
2.2.1 Households.........................................................................................................................16
2.2.2 Consumer Goods Firms and Markets..................................................................................16
Introduction
The foundation of macroeconomics, as a separate branch of economics, was laid down by
John Maynard Keynes (1883 – 1946). Since the 1970s, probably encouraged by the ‘Lucas
Critique’, many macroeconomists insist on a explicitly modeled ‘microfoundation’ of
macroeconomics—as opposed to ‘Keynesian’ macroeconomics, where an explicit model is
only existing on the aggregate level. This development resulted in the status quo of
macroeconomic research: Since the early 1990s almost all important developments in the
branch of macroeconomics were made by research based upon ‘Walrasian microfoundation’
(typically ‘Dynamic Stochastic General Equilibrium’ models). The central problem of this
approach, as we see it, is the relation between micro and macro structure: In the
overwhelming majority of applications, the ‘microfoundation’ of ‘General Equilibrium’
models is (according to simplification) built on the aggregate level. Obviously, this does not
solve the essential problem of macroeconomics, namely how individual (i.e. microeconomic)
behaviour generates the dynamics on the aggregate (i.e. macroeconomic) level.

As an alternative approach, in recent years the agent–based simulation technique has

emerged. This was enabled by a rapid improvement of computing power of IT systems and
by the development of sophisticated programing languages. As a result of this development,
the question arose, what is the main difference between the traditional ‘General Equilibrium’
framework in contrast to this new approach? We see the borderline between both approaches
in the fact that agent–based macroeconomic models are built bottom–up, while ‘orthodox’
models are, as stated above, designed top–down on the macro level. Opposed to that, agent–
based models are designed on the micro level. They contain about several thousand
individual agents, and the researcher usually does not constrain the macro level through
specifications, which are necessary to compute (or better to run) the model (or the
simulation). The modeler of an agent–based computer simulation only observes the generated
macro dynamics of the simulation, while he designs the model solely on the basis of
individual behaviors and interactions. Basically, this approach is related to the theory of
‘complex systems’. The named ‘complex system’ consists of interconnected parts; its
properties, as a whole, are not necessarily represented by the properties of the individual
parts. Interestingly, older neoclassics (foremost represented by Alfred Marshall) thought of
economics as a representation of a ‘complex system’—but they did not possess the
mathematical tools to solve dynamic applications of such ‘complex systems’. This situation
has changed by the advent of agent–based computer simulations.

This description leads us to the phenomenon that the benefits of agent–based modeling,
which stem from its flexibility, are sometimes challenged by economists: The often heard
criticism is that a scientific theory must be based upon ‘abstraction’, and that the agent–based
modeling opens a door for the (more or less detailed) ‘replication’ of reality. But such a
‘replication’ would overload an economic model. It would lead to complex interrelations
which cannot build the solid groundwork for economic theory–building. This would oppose
the idea of ‘abstraction’ as a basis of scientific research. The key criticism is therefore that
scientific models should be far less complex than reality. We want to survey the relation
between ‘abstraction’ and agent–based modelling in a different perspective. One can define
‘abstraction’ as the process (or result) of generalization by reducing the information content
of a problem the researcher is interested in. It is crucial that this reduction takes place in order
to retain only that information which is relevant for the particular purpose. Therefore, our
central question should be, which information is of pivotal importance in the context of
macroeconomics?
Macroeconomic research, as we see it, should retain the emergence of macro structure out of
micro behaviors and interactions. This macroeconomic emergence and the according theory
of ‘complex systems’ should be central issues in each complete macroeconomic
investigation. Unfortunately, until now almost no research is carried out with respect to this
research question in the field of dynamic monetary macroeconomics. The present study aims
to close this gap. Hence, we designed an agent–based macroeconomic model that is
structured bottom–up, so that its aggregate dynamics develop out of both micro behaviours
and micro interactions. As we will see, this leads to complex and non–linear micro–macro
interactions. In this sense, our approach is related to Joshua M. Epstein’s notion coined by the
expression: “If you didn’t grow it [author’s note: the macro model], you didn’t explain its
emergence” (Epstein, 2006a, p. 9). Against this background, it is not legitimate to conclude
that the complex micro–macro interrelations account for an unfavorable departure from
‘abstraction’. The mentioned complexity is, in our view, the crucial feature of a
macroeconomic system. It is therefore not legitimate to dispose these characteristics by
‘abstraction’, as usually done in ‘orthodox’ economics.

Objectives of the Study

The present study can be placed into the field of agent–based computational economics. As
we will discuss in chapter 1, the agent–based technique enables a flexible way of designing,
simulating and analyzing a particular model structure. In here, the structure of the model
represents an intuitive analogy to reality. In addition, the benefit of flexibility induces the
question, as to what extend the generated model is the ‘right’ one for a defined purpose? This
is the subject of the model ‘validation’. According to this, ‘validation’ is the key issue in
agent–based research. Most importantly, our main purpose is therefore to develop a
reasonably validated agent–based macroeconomic simulation model. Moreover, we have to
outline the objectives the model is built for: The presented model needs to be a dynamic
macro model. Its main innovation with respect to agent–based modeling is its ‘monetary
circuit’ or ‘monetary sphere’. As opposed to other agent–based research, the presented model
belongs to the field of monetary macroeconomics. Equally important, the model has to
contain ‘Keynesian’ and ‘Wicksellian’ elements. The former elements indicate several
important ‘Keynesian’ properties, such as the importance of the demand side, the ‘paradox of
thrift’, and so on. The latter elements impliy the role of the central bank and monetary policy.
Accordingly, the presented model contains a central bank agent that conducts monetary
policy through an interest rate instrument. Thereby, the basic framework is constituted by
Knut Wicksell’s idea of a monetary transmission mechanism. The second aim of this study is
closely connected to the first one. The objective to construct a first agent–based monetary
macro model causes the problem that we cannot use any existing framework. Therefore, the
second purpose of this study is to develop a guideline for future work in this field. Here, the
focus lies (i) on methodological aspects. As we will see, agent–based computational
economics constitutes an IT–based tool, which enables to simulate a certain model structure
—it is not a methodological basis for the model structure. Consequently, we have to define a
methodological framework for the modeling. According to the important role of the
‘validation’ task, we must, in addition, elaborate an appropriate ‘validation’ methodology.
Those two methodological questions have to be answered. (ii) Secondly, our guideline
focuses on the theoretical aspects of the model. Therefrom, it is our aim to refer to the
theoretical roots of the presented model—especially in context of its ‘monetary circuit’. On
the other part, we do not want to discuss all technical aspects, which are needed to conduct an
agent–based research in principle. (iii) Thirdly, we identify some pitfalls that one could
experience in carrying out research such as the presented one. Therefore, we will give advice
how to identify possible sources of problems.
Structure of the Study

The structure of this study is straightforward: Chapter 1 gives a propaedeutic survey of the
main topics of agent–based research. One challenge is thereby is to discuss the
methodological aspects, such as the basic methodologies of the modeling and ‘validation’
approaches. The subsequent chapter establishes the conceptual model. It gives an detailed
overview of the theoretical roots and antecedents of the model, and it outlines the reasons for
the chosen design. We will also address problems of model design in this context. The study
finishes with a comprehensive model ‘validation’ in chapter 3. This is executed in several
stages, which are built on each other. The methodology of this ‘validation’ procedure is
prepared in chapter 1. The study ends with concluding remarks.

The foundation of macroeconomics, as a separate branch of economics, was laid down by

John Maynard Keynes (1883 – 1946). Since the 1970s, probably encouraged by the ‘Lucas
Critique’, many macroeconomists insist on a explicitly modeled ‘microfoundation’ of
macroeconomics—as opposed to ‘Keynesian’ macroeconomics, where an explicit model is
only existing on the aggregate level. This development resulted in the status quo of
macroeconomic research: Since the early 1990s almost all important developments in the
branch of macroeconomics were made by research based upon ‘Walrasian microfoundation’
(typically ‘Dynamic Stochastic General Equilibrium’ models). The central problem of this
approach, as we see it, is the relation between micro and macro structure: In the
overwhelming majority of applications, the ‘microfoundation’ of ‘General Equilibrium’
models is (according to simplification) built on the aggregate level. Obviously, this does not
solve the essential problem of macroeconomics, namely how individual (i.e. microeconomic)
behaviour generates the dynamics on the aggregate (i.e. macroeconomic) level.

As an alternative approach, in recent years the agent–based simulation technique has

emerged. This was enabled by a rapid improvement of computing power of IT systems and
by the development of sophisticated programing languages. As a result of this development,
the question arose, what is the main difference between the traditional ‘General Equilibrium’
framework in contrast to this new approach? We see the borderline between both approaches
in the fact that agent–based macroeconomic models are built bottom–up, while ‘orthodox’
models are, as stated above, designed top–down on the macro level. Opposed to that, agent–
based models are designed on the micro level. They contain about several thousand
individual agents, and the researcher usually does not constrain the macro level through
specifications, which are necessary to compute (or better to run) the model (or the
simulation). The modeler of an agent–based computer simulation only observes the generated
macro dynamics of the simulation, while he designs the model solely on the basis of
individual behaviors and interactions. Basically, this approach is related to the theory of
‘complex systems’. The named ‘complex system’ consists of interconnected parts; its
properties, as a whole, are not necessarily represented by the properties of the individual
parts. Interestingly, older neoclassics (foremost represented by Alfred Marshall) thought of
economics as a representation of a ‘complex system’—but they did not possess the
mathematical tools to solve dynamic applications of such ‘complex systems’. This situation
has changed by the advent of agent–based computer simulations.

This description leads us to the phenomenon that the benefits of agent–based modeling,
which stem from its flexibility, are sometimes challenged by economists: The often heard
criticism is that a scientific theory must be based upon ‘abstraction’, and that the agent–based
modeling opens a door for the (more or less detailed) ‘replication’ of reality. But such a
‘replication’ would overload an economic model. It would lead to complex interrelations
which cannot build the solid groundwork for economic theory–building. This would oppose
the idea of ‘abstraction’ as a basis of scientific research. The key criticism is therefore that
scientific models should be far less complex than reality. We want to survey the relation
between ‘abstraction’ and agent–based modelling in a different perspective. One can define
‘abstraction’ as the process (or result) of generalization by reducing the information content
of a problem the researcher is interested in. It is crucial that this reduction takes place in order
to retain only that information which is relevant for the particular purpose. Therefore, our
central question should be, which information is of pivotal importance in the context of
macroeconomics?

Macroeconomic research, as we see it, should retain the emergence of macro structure out of
micro behaviors and interactions. This macroeconomic emergence and the according theory
of ‘complex systems’ should be central issues in each complete macroeconomic
investigation. Unfortunately, until now almost no research is carried out with respect to this
research question in the field of dynamic monetary macroeconomics. The present study aims
to close this gap. Hence, we designed an agent–based macroeconomic model that is
structured bottom–up, so that its aggregate dynamics develop out of both micro behaviours
and micro interactions. As we will see, this leads to complex and non–linear micro–macro
interactions. In this sense, our approach is related to Joshua M. Epstein’s notion coined by the
expression: “If you didn’t grow it [author’s note: the macro model], you didn’t explain its
emergence” (Epstein, 2006a, p. 9). Against this background, it is not legitimate to conclude
that the complex micro–macro interrelations account for an unfavorable departure from
‘abstraction’. The mentioned complexity is, in our view, the crucial feature of a
macroeconomic system. It is therefore not legitimate to dispose these characteristics by
‘abstraction’, as usually done in ‘orthodox’ economics.

Objectives of the Study

The present study can be placed into the field of agent–based computational economics. As
we will discuss in chapter 1, the agent–based technique enables a flexible way of designing,
simulating and analyzing a particular model structure. In here, the structure of the model
represents an intuitive analogy to reality. In addition, the benefit of flexibility induces the
question, as to what extend the generated model is the ‘right’ one for a defined purpose? This
is the subject of the model ‘validation’. According to this, ‘validation’ is the key issue in
agent–based research. Most importantly, our main purpose is therefore to develop a
reasonably validated agent–based macroeconomic simulation model. Moreover, we have to
outline the objectives the model is built for: The presented model needs to be a dynamic
macro model. Its main innovation with respect to agent–based modeling is its ‘monetary
circuit’ or ‘monetary sphere’. As opposed to other agent–based research, the presented model
belongs to the field of monetary macroeconomics. Equally important, the model has to
contain ‘Keynesian’ and ‘Wicksellian’ elements. The former elements indicate several
important ‘Keynesian’ properties, such as the importance of the demand side, the ‘paradox of
thrift’, and so on. The latter elements impliy the role of the central bank and monetary policy.
Accordingly, the presented model contains a central bank agent that conducts monetary
policy through an interest rate instrument. Thereby, the basic framework is constituted by
Knut Wicksell’s idea of a monetary transmission mechanism. The second aim of this study is
closely connected to the first one. The objective to construct a first agent–based monetary
macro model causes the problem that we cannot use any existing framework. Therefore, the
second purpose of this study is to develop a guideline for future work in this field. Here, the
focus lies (i) on methodological aspects. As we will see, agent–based computational
economics constitutes an IT–based tool, which enables to simulate a certain model structure
—it is not a methodological basis for the model structure. Consequently, we have to define a
methodological framework for the modeling. According to the important role of the
‘validation’ task, we must, in addition, elaborate an appropriate ‘validation’ methodology.
Those two methodological questions have to be answered. (ii) Secondly, our guideline
focuses on the theoretical aspects of the model. Therefrom, it is our aim to refer to the
theoretical roots of the presented model—especially in context of its ‘monetary circuit’. On
the other part, we do not want to discuss all technical aspects, which are needed to conduct an
agent–based research in principle. (iii) Thirdly, we identify some pitfalls that one could
experience in carrying out research such as the presented one. Therefore, we will give advice
how to identify possible sources of problems.

Structure of the Study

The structure of this study is straightforward: Chapter 1 gives a propaedeutic survey of the
main topics of agent–based research. One challenge is thereby is to discuss the
methodological aspects, such as the basic methodologies of the modeling and ‘validation’
approaches. The subsequent chapter establishes the conceptual model. It gives an detailed
overview of the theoretical roots and antecedents of the model, and it outlines the reasons for
the chosen design. We will also address problems of model design in this context. The study
finishes with a comprehensive model ‘validation’ in chapter 3. This is executed in several
stages, which are built on each other. The methodology of this ‘validation’ procedure is
prepared in chapter 1. The study ends with concluding remarks.

Chapter 1. A Road Map to an Agent–Based Computational Macro

Model
An economy is an evolving, complex, adaptive, and dynamic system. Other scientific fields
than economics made much progress in the study of similar systems, which feature the same
basic elements, such as heterogenous and autonomous entities (agents) that are engaged in
complex interaction profiles, while the macro behavior of the system as a whole emerges out
of micro structures, micro behaviors and micro interactions. The aggregate behavior emerges
bottom–up. Such approaches are found in the fields of medicine and brain research, logistics,
ecology and biology. Within those fields, computer modeling and experimentation is widely
accepted (without much question) as valuable tools. On the contrary, to this date agent–based
analysis did not attract great attention in economics, and in macroeconomics in particular.
This can be due to the fact that macroeconomists are averse to agent–based approaches
(Leijonhufvud, 2006a). The reasons for this phenomenon are shrewdly characterized by Axel
Leijonhufvud:

“The apparent threat of cognitive loss is perhaps steeper in macro than in other areas. Each
generation of scholars inherits a knowledge base of theory, of empirically confirmed ‘facts’
and of investigative techniques. Inherent in this base are directions for future work—which
problems are interesting and which ones not, what facts are puzzling and which ones can be
taken for granted, what methods of investigation are approved and not approved, and so forth.
The macroeconomics of the last century, from Lucas through Presccot to Woodford, has been
strongly wedded to stochastic general equilibrium theory It is the well–developed knowledge
base with which the last couple of generations of macroresearchers have been equipped.
Acquiring it required a large investment. But then recruits to this research program are
confident that their technical equipment is the best in the business.” (Leijonhufvud, 2006a, p.
1627).

The objective of this chapter is to discuss an alternative framework based upon the agent–
based simulation technique. Hence, this chapter illustrates the main aspects of the approach
of agent– based computational economics (ACE) and its advantages compared to ‘General
Equilibrium’ (GE) theory. In the last section, we will describe a suitable ‘validation’
framework for the development of an agent–based macroeconomic model. As we will see,
‘validation’ is the core issue within agent– based research. Moreover, this chapter defines the
main concepts of agent–based models, which are in turn necessary to develop and validate
the model throughout the remainder of this study.

What is Agent–Based Computational Macroeconomics?

Imagine the total number of economic processes, such as producing and trading, happening in
any economy in reality. They are usually driven by the actions of hundreds of thousand
individuals, social groupings or institutions. In many circumstances information technology
systems (IT systems) support the execution of such actions. The basic idea of an IT system is
to map real actions, facts and circumstances into digital data. Especially firms utilize IT
systems to improve the efficiency of business processes: Suppose a supplier in the
automotive industry, where an ‘enterprise resource planning system’ (ERP system in brief)
collects the data of production and logistic processes. This system provides suitably prepared
and presentable data in order to allocate business resources (materials, employees), for
example through the scheduling of new orders or the minimization of inventory costs.
Inevitably, the operations of the ERP system requires the interconnection between the real
business processes and the respective data inventory within the IT system. Hence, there have
to be some exogenous actions affecting the ERP system. This means, for example, that the
data inventory has to be updated on condition that the stock of inventory of the automotive
supplier has changed. Such maintenance can be operated manually by the users of the IT
system, as well as semi or fully automatically.
In summary: The ERP system supplies information and data about business resources to the
automotive supplier. However, some systems—such as complex ‘Supply Chain
Management’ (SCM) systems—contain fully automated processes due to the use of robots.
These robots react automatically to a change in the data. For example, provided that the stock
of inventory of an intermediate product needed in the production process of an automotive
supplier (such as the stock of inventory of unmachined engine hoods) falls short of a certain
level (e.g. 1,000 engine hoods), the robotic agent starts a fully automatic digital procurement
process via a network (presumably via the internet).
This means that the software agent executes a routinized search for suitable offer(s) in one or
more online trading platforms, where suppliers and buyers of certain intermediate products
meet. Such processes can appear on several stages of a vertical value added chain in a more
or less automatic sense. A SCM system therefore collects, maintains and delivers data—but it
can also feature automated elements where, for example, robotic trading happens. As a
consequence, real business processes are affected by the information system automatically
through robots, causing true interaction between real processes and the IT system. It is
important that such an active role of the IT system must be guided by a rule–based or
routinized behavior of the software agents. This behavior can even represent some kind of
‘artificial intelligence’. In a next step, we can reveal the basic idea of agent–based
simulation2 technique by using these introductory explanations: Like ERP or SCM systems,
an agent–based computer simulation collects first of all digital data. It is populated by many
agents, and each of these agents features a certain data set. The point is that the data set is not
a direct representation of facts or information about reality as is the case in an ERP or SCM
system. Rather, the data inventory of agents represents an abstract model, which is in turn the
simplified representation of certain relationships known from reality. Accordingly, agent–
based computational economics build upon the construction of an artificial world, in which all
actions are completely endogenous. This world covers special aspects of the real world we are
interested in. The present study is interested in the behavior of a closed economy, i.e. the subject of
the study is an an artificial world which represents an extremely simplified national economy
encompassing the basic economic sectors.
Within this artificial world, data are permanently generated, collected, and manipulated endogenously
on the micro level. The key difference between the common (every–day) usage of information
technology (e.g. as represented by an ERP system) and an agent–based computer simulation is that in
the former at least some degree of interaction between reality and the information system is necessary,
whereas in the latter all decisions, actions, and processes are fully automated—the agent world is
autarchic.3 This implies that an agent–based computer simulation contains agents, which are
routinized robots, and which stand for the actors in the real processes we are interested in. This, in
fact, represents basically the intuitive modeling approach of agent–based computer simulations.
Moreover, such simulations are somewhat similar to complex SCM systems, in which robot agents
are employed: If an agent simulation is started, each robot behaves exclusively according to the
programed routines, so that no connection between the real world (e.g. the designer) and the
simulation (run) prevails.
To sum up, an agent–based computational simulation contains an autarchic artificial world containing
robot agents represented by a set of data and rules (or routines). In the following paragraph we
illustrate such an artificial world representing the subject of the present study. Imagine the artificial
world of Agent Island. Agent Island is a autarchic world populated by firm and household robot
agents. If the computer simulation is started, the population arrives on Agent Island. Upon arrival
each agent receives his personal data and instruction booklet: This booklet contains a set of rules and
restrictions the agent has to follow as well as the initial data set. If the agent is trading any goods or
services throughout the simulation, he has to register the movements in the data entries in his booklet.
The agent–based simulation technique therefore supplies all possible data (individual, aggregate or
otherwise manipulated data) to the researcher. The researcher can request the data entries in the
booklets of those agents he is interested in. Data entries in the booklet of all agents are the basis for
the routinized decisions and behaviors of the agents. That is, an agent uses these data together with the
routines in his booklet in order to operate decisions and actions. Routines define therefore the
processes of the agent (e.g. production or trading processes). Thereby, routines need not be static,
insofar as they can evolve over time—again according to simplified and routinized adaption behavior.
In addition, we use a round–based simulation approach, and the agents employ data to their routines
once a round. If all routinized decisions and actions are conducted, the economy on Agent Island
enters the next round. At the end of each round we collect data on aggregate levels, because the
business cycle dynamics of the Agent Island economy is the topic we are ultimately interested in. As
suggested by intuition, we have to design the individual sets of data and rules for all relevant aspects
of the model—for each agent of the Agent Island population. To give an idea of such an design, the
following subsections highlights some important aspects of ACE. The next subsection illustrates the
main conceptual building blocks. Thereafter, we describe which research objectives can be pursued
within such a model, and which ingredients are necessary. Finally, the introduction closes with the
discussion of the methodological relevance of ACE.

1.1.1 Conceptual Building Blocks

Agent–based models can be characterized by several concepts. However, this subsection does not give
an in–depth review of these theoretical concepts; the objective is rather to outline the relevant building
blocks of an agent–based computational model and relate them to the framework of Agent Island. We
will discuss in section 1.2 the virtues of agent–based computational economics by comparing the
‘orthodox’ framework of macroeconomics with the possibilities of ACE. Thereby, we will take up the
conceptual building blocks again and deal with them in somewhat greater detail. The following
overview therefore summarizes the main building blocks of ACE in brief: Bottom–up perspective and
macroeconomic emergence Traditional ‘neoclassical’ models follow a top–down perspective, where
the aggregate level typically comprises a ‘representative agent’. In contrast, agent–based models build
on an environment, in which micro entities engage in repeated interactions. As in reality, the dynamic
on the macro level emerges from the behavior of the basic entities on the micro level (Windrum and
Moneta, 2007; Pyka and Giorgio, 2005; Tesfatsion, 2003). It is thus intuitive that Agent Island is
designed bottom–up. This corresponds to the assumption that the agents, upon arriving on Agent
Island, receive a personal data and instruction booklet. The macro behavior of the economy of Agent
Island emerges from repeated individual actions and interactions according to the instructions and
data in the booklets. Such an approach allows us to investigate the relationship between micro and
macro dynamics. This is done during the ‘validation’ process in chapter 3. The relationship between
micro and macro properties is of particular importance, when one is interested in the analysis of
‘fallacies of composition’ in economics.4 Heterogeneity Agents might be heterogenous in almost all
characteristics, i.e. with respect to data or behavior. The former might be defined through varying
variables or initial values of some variables (Pyka and Giorgio, 2005).
The latter is based upon varying behavioral rules or, at least, levels of behavioral parameters within
one rule. According to that, the personal data and instruction booklets of the population of Agent
Island reflect this heterogeneity. In here, we simplify by the assumption that agents of the same type
(households, consumer goods firms, capital goods firms) receive the same rules, but the level of the
parameters in the rules can vary. Network direct interactions: Interactions among agents are direct and
inherently non–linear. This means that the decisions of an agent depend to some extend on the past
and present choices made by all other agents (Pyka and Giorgio, 2005). Moreover, in ACE the trading
and procurement processes are usually modeled explicitly, which implies that the institution of the
‘Walrasian auctioneer’ is not mandatory (Tesfatsion, 2006). Consequently, it is possible to employ
various forms of procurement processes within an agent–based model. In particular, ACE enables
‘face–to–face’ interactions within a procurement process. We will explain below that such a ‘face–to–
face’ procurement process is adopted in the market for capital goods on the island. Then again, the
consumer goods market is working simplified in institutional analogy to ‘orthodox’ economics (viz.
by employing implicitly some kind of auctioneer).
Bounded rationality By its nature, the environment on Agent Island is too complex to apply hyper–
rationality. This is for example apparent in the context of expectation formation, because agents on
Agent Island are not able to derive rational expectation outcomes, as in ‘orthodox’ models. Rather,
one has to apply routinized outcomes of myopic optimizations in combination with adaptive
expectations. The latter is necessary, because agents face ‘true uncertainty’5 so that expectations
cannot be rational as assumed by ‘orthodox’ economic theory. According to this, the agents on Agent
Island face ‘true uncertainty’, so that they do not know (and cannot calculate) the future outcome of
economic interactions on the island. This must affect the formation of expectations in such a way that
expectations are adaptive. Learning Behavior In many ACE models sophisticated learning algorithms
are implemented (Tesfatsion, 2006; Windrum and Moneta, 2007).6 Not so in the present study. In a
first step of the development of the model, we have employed such a complex and sophisticated
learning algorithm. As suggested by Tesfatsion, 2006, we have applied it to the supply decision of
consumer goods firms. Unfortunately, this design produced undesired effects on the macro level, i.e.
the assumed ‘Phillips curve’ relationship (viz. the positive correlation between output gaps and
inflation rates) was upside down. Therefore we abandoned this approach and have adopted a more
suitable approach for the supply decisions, as it will be described in subsection 2.2.2. In this approach,
firms adopt their behavior to a change in the environment on Agent Island, but a complex learning
algorithm is absent.

1.1.2 Objectives
The following description illustrates four main objectives of agent–based research. If necessary, we
extend each description by a short link to the objectives of the present study: Empirical understanding
In this case the researcher has to investigate the question, why certain empirical phenomena or
regularities evolve. They seek for causal explanations for such phenomena through agent–based
environments (Tesfatsion, 2006). Based upon empirical understanding an agent–based simulation can
deliver predictions of future tendencies or events (Gilbert and Troitzsch, 2005). Normative
understanding An agent–based model can deliver normative insights as well (Tesfatsion, 2006). It is
certainly possible to compare various policies (e.g. various central bank strategies) based upon a valid
8 agent–based model. The crucial point is the ‘validation’ of the ACE model. Even though we do not
chase after any normative objectives, our analysis could to some extend be useful for further
normative postulates. It delivers a correctly validated model, which is necessary to conduct a
normative analysis.9 Our objective is to deliver such a model: This could be a starting point for
normative analyses in the future or, at least, a foundation for the further development of a valid
monetary macro model that in turn could be used for a normative analysis. Methodological
advancement The question of interest is, how best to provide agent–based researchers with a suitable
methodology needed to undertake a study of the economic system. Thereby, researches need to model
structural, institutional and behavioral characteristics of the economic system; they ought to evaluate
the logical validity of their model through computer experiments, and test their theories against real–
world data (Tesfatsion, 2006). Due to the flexibility of agent–based models, those requirements can be
fulfilled through a variety of ways. If the researcher is able to find a proper way for doing this, he
develops further methodological insight with respect to the topic of interest. In the context of the
present study, this is one aim. We strive for the development of a reasonable validated agent–based
monetary macro model. This should become the basis for further analysis of monetary policy issues.
In addition, we apply a ‘validation’ framework developed in the field of computer science (see section
1.3.3), which has never been applied to an economic issue until now. Accordingly, we wish to deliver
a suitable framework for further research in monetary macroeconomics within the field of agent–
based computational economics. Qualitative insight and theory generation Through research in agent–
based models one can gather new insights about an economic issue of interest. An agent–based
simulation can be used as a method of theory development, in order to improve the understanding of
phenomena of the social world (Gilbert and Troitzsch, 2005). Consequently, a well–designed and
suitable agent– based world can improve the understanding of the dynamic behavior of a complex
economic system. Usually, this objective is based upon the systematic examination of simulation
inputs10 (initial values, behavioral and structural parameters, etc.) and their impact on simulation
outputs of interest (Tesfatsion, 2006). The last point expounds the idea that ACE has the potential to
assist in the discovery and formalization of theories. Researchers can investigate theories in the
artificial agent world they have built. In order to do this, the researchers have to take theories
expressed in textual or conceptual form and formalize them into a specification which can be
programed into the computer. According to this, the theory will be precise, coherent and complete. In
this respect agent–based computer simulations could feature a similar role in social sciences,
comparable to that of mathematics in the physical science (Gilbert and Troitzsch, 2005). On the
contrary, mathematics have been widely used as a means of formalization in economics and
econometrics. In fact, there are several reasons why agent–based simulations are more appropriate to
social science than mathematics (Gilbert and Troitzsch, 2005). We will explain these main virtues of
agent–based computational economics in section 1.2, and, in addition, compare them to ‘orthodox’
economic modeling (which is solely based on the mathematical framework of ‘optimal control
theory’). Inevitably, the presented model of Agent Island illustrates how the formalization of an
agent–based monetary macro model can look like.

1.1.3 Ingredients
The following overview contains a broad set of ingredients, each agent–based computational model
consists of (see Pyka and Giorgio, 2005): Time As an agent–based model is by its nature a dynamic
model, we have to define the time perspective of the model. As we will see, the model is round–
based, i.e. it evolves in discrete time steps, which we define as periods. Next to this period time (T =
1, 2, ...), there exists an intra–period time. The sequence of decisions and actions within one period is
based upon the concept of intra–period time. Hence, when one period ends, the intra–period sequence
restarts. Agents Each agent–based simulation is populated by a set of agents. The term ‘agent’ refers
to bundled data and methods (or routines). It represents an entity constituting a part of a world
constructed by computation. Agents can be (i) individuals (e.g. consumer, workers), (ii) social
groupings (e.g. families, firms, government agencies), (iii) institutions (e.g. markets), (iv) biological
entities (e.g. livestock, forest), and physical entities (e.g. weather, geographical regions) (Tesfatsion,
2006). In context of the present task, viz. the development of a monetary macro model, agents
represent the actors within the opted framework, viz. households (i.e. consumers/workers), firms (i.e.
consumer goods and capital goods firms) and the central bank. It should be noted that we assume a
constant set of agents. The existing agents do not die (drop out), and no new agents are born during a
simulation run. Thus, the once initialized population outlasts the whole simulation run. In general,
agents are supposed to be (i) autonomous entities (i.e. the state of the agent and its actions are first of
all independent from its environment or other agents), (ii) social entities (i.e. agents are able to
interact with other agents), (iii) reacting entities (i.e. agents are able to perceive their environment,
which usually leads to a reaction), (iv) active entities (i.e. agents are able to initiate actions
themselves) (Pyka and Giorgio, 2005). Micro variables Each agent is characterized by a vector of
microeconomic (state) variables. Those variables are usually supposed to be modified endogenously
throughout the simulation. In our model such microeconomic variables are, for example, the net
financial wealth (or net debt) of a household agent, or the real capital stock of a firm agent, or the
produced/supplied output of firms, and so on. During the ‘validation’ of the model it is one task to
define reasonable initial values of several microeconomic variables (such as the initial capital stock of
firms). Micro parameters Next to the micro variables each agent is characterized by a vector of
microeconomic parameters. Parameters are variables that cannot be endogenously adapted throughout
a simulation run. Typically, such parameters describe the behavior of the agent (behavioral
parameters) or certain restrictions (structural parameters). For example, the supply decision of a
consumer goods firm is defined via a behavioral parameter. This parameter connects the
produced/supplied output of the present period to the marginal profitability of one output unit in the
last period. Moreover, this supply decision is restricted by a structural parameter characterizing the
production function. To highlight the important micro parameters of the model we label them through
lower case Greek letters. Macro parameters The system as whole is characterized by a vector of
macroeconomic parameters. Similar to micro parameters, macro parameters cannot be modified
endogenously, i.e. once fixed to a certain level, these values remain unchanged. In the present model,
the technological progress is represented through a ‘random walk process’ defined by two parameters,
namely by a ‘drift term’ and the variance of the ‘white noise’ term. Such a technical progress is
constituted on the global level (i.e. for the whole economy) and on individual firm levels. A
combination of both figures constitutes the individual technical change of a firm. Besides this, on the
global level the ‘drift term’ and the variance are defined by two macro parameters. We call such
macro parameters also global parameters. To highlight the important macro parameters of the model
we characterize them also through lower case Greek letters. Macro (or aggregate) variables Finally,
there exists a set of macroeconomic variables. Usually, such variables (such as the GDP) emerge
through some kind of aggregation of micro variables. Other macro variables are by nature defined on
the macro level (e.g. the credit interest rate). We call macro variables also global variables. Interaction
structure The interaction structure controls the flow of information between agents. Consider firm
agents that are trading on the capital goods market. Provided that two specific agents close a contract
for the sale of a capital good (i.e. a machine), the seller updates his order book, while the buyer books
a purchase order. Simultaneously, the account is settled by the buyer. According to that, the cash
reserve of the buyer decreases, while the cash reserve of the seller increases by the same amount.
Besides this, there is a third party involved in this payment process, as we apply a banking system to
the model. Thereby, subsequent actions of each of the parties (in the next period) can be affected by
that trading. According to this rather simple example, on can imagine that relatively complex
interaction structures emerge on Agent Island. Micro decisions rules Each agent is endowed with a set
of decision rules. Such rules are routines, which map observable figures (past micro variables and
macro variables or parameters) into present micro variables. Such a mapping process is based upon
the micro parameters (i.e. behavioral or structural parameters) of the individual agent. It can also
contain stochastic elements, if necessary. The concept of decision rules is crucial to agent–based
models. It mirrors the notion of routinized behavior, known from ‘evolutionary’ economics (see
explanations below). As we will discuss later on, micro decision rules based upon micro parameters
define the ‘genes’ of the agents. Space In principle, it is possible that an agent–based computational
model features a spatial dimension. For example, the real map of a landscape could serve as the
environment, in which agents live, produce and trade. This enables a more specific perspective on
trading and other interactions. However, for the sake of simplicity we do not integrate such a spatial
dimension to Agent Island.

1.2 Virtues of Agent–Based Computational Macroeconomics

In this section we review the weakness of the orthodox approach to macroeconomics, and confront
these weaknesses with the virtues of agent–based computational economics. In here, we subsume both
the (neoclassical) ‘Walrasian’ GE approach and the ‘New Keynesian’ framework16 of monetary
theory under the term ‘orthodox’ economics. In fact, all modern models that belong to the group of
‘orthodox’ economics are rooted in the Walras or Arrow–Debreu framework.17 This section reviews
some assumptions and aspects of these models—namely those aspects which are subject to criticism.
In order to illustrate the main positions of orthodox economics and compare them to the agent–based
approach, we introduce a nearby island to Agent Island. The artificial economy of this neighbour
island is built upon a different structure compared to Agent Island. The following paragraphs illustrate
that. Population The economy of the neighbor island of Agent Island is constituted by a
‘representative agent’.18 Now, what is, or rather what does the ‘representative agent’ in the artificial
island economy? Gun, 2004, characterizes the idea of the the ‘representative agent’ unequivocally:
“However, the representative agent of new macroeconomics is not ‘representative’ in this way [note
of the author: here, ‘this way’ means representing a lot of different people]: He is identical with the
people he ‘represents’—because only identical persons are considered. Why are only identical persons
considered? Because aggregation of non–identical agents creates problems. But, if people are
identical, they have no reason for trading (exchange results from differences, in tastes, endowments,
technologies): the situation is exactly the same if there is one or ‘many identical’ persons.
‘Representative agent’ is, thus, another name for Robinson Crusoe: new macroeconomics is ‘Crusoe
microeconomics’ and, therefore, devoid of usefulness—it is even a regression in comparison with the
‘old’ (IS–LM) macroeconomics. Moreover, it is nonsense. New macroeconomists probably feel this,
as they practically never try to justify the representative agent assumption. In the alphabetical index,
at the end of their books or textbooks, they often ‘forget’ to mention him (as also happens with the
‘auctioneer’, in the index of microeconomic textbooks).” (Gun, 2004, p. 120) Thereby the crucial
point of the assumption that such an economy is populated by many identical households is not the
word ‘many’—rather, the key word is ‘identical’ (Gun, 2004). This notion implies that the many
agents can be represented by one single agent. For this reason, we call this island subsequently
Robinson Crusoe Island. The need for the modeling of the ‘representative agent’, which is indeed a
pretty strong simplification, lies in its simplicity: It reduces the complexity of the orthodox framework
in order to get stable and unique equilibria (Fagiolo and Roventini, 2008). Another study describes the
failure of modern ‘representative agent’ macroeconomics in the following way: “[...] it seems
worthwhile to review why Walrasian microfoundations should be considered as the wrong answer to
what is probably the most stimulating research question ever raised in economics, that is to explain
how a completely decentralized economy composed of millions of (mainly) self–interested people
coordinate actions.” (Gaffeo et al., 2007, p. 91) Hence, the ‘representative agent’ living on Robinson
Crusoe Island represents not a component, simpler than the system of which he is part (Leijonhufvud,
2006a). This would be an intuitive assumption of an economy and its parts. The idea that the whole
system is more complex than the part it is made up of, is one core assumption of ‘complex system
theory’. In addition, such a system consists of interrelated components. Not so the economy of
Robinson Crusoe Island. Its economy is reduced to a unique single agent. But this contradicts the very
essence of microeconomics, because without diversity of agents, there cannot be any exchange (Gun,
2004). A good critical review of the ‘representative agent’ approach is delivered by Kirman, 1992. He
finds at least five major aspects of criticism to the ‘representative agent’, which summarize the core
problem of this approach: (i) Individual rationality does not imply aggregate rationality. This means
that one cannot provide any formal justification for the assumption that the maximizing individual
behavior could be applied to the aggregate level. (ii) The reaction of the ‘representative agent’ to
shocks cannot coincide with the aggregate micro reactions of individuals. (iii) Even if the above
mentioned problems are solved, other cases are existing where out of two given situations x and y, the
‘representative agent’ would prefer x, while all the individual agents would prefer y. (iv) There
appears an additional problem at the empirical level. If one tests a theory delivered by a
‘representative agent’ model, one is also jointly testing the ‘representative agent’ hypothesis. (v)
Finally, in case of heterogenous agents, it is implied that basic properties of linear dynamic micro
properties are not preserved by aggregation. For example, the aggregation of static micro–equations
could produce dynamic macro equations (Froni and Lippi, 1997). We want to finish the discussion of
the ‘representative agent’ living on Robinson Crusoe Island by a pointed picture delivered by Gun,
2004: “But, at the same time, they present representative models as positive models, and try to fit the
model with existing data (through ‘calibration’ and other techniques): observed GDP, employment,
consumption, investment of a country during, say, 10 years, are thus compared with what a
representative agent’s intertemporal choice would be–taking into account observed ‘shocks’. This is
total nonsense: How can any reasonable person admit that, for example, the evolution of the US
aggregates’ results from decisions made by a single individual who owns all factories and who
decides how much to produce, how much labor to use, how production will be distributed between
consumption and investment, and so on? It is quite incredible that the majority of a profession (which
pretend to be ‘scientific’) readily indulges in this kind of absurdity, teaches it, and does a lot of
‘research’ on it—with maths, statistics, and computers—attempting to specify the representative
agents ‘parameter’ (that is, coefficients in his utility and production functions) which allow good fits
with observed data.” (Gun, 2004, p. 121) In contrast to this view, agent–based computational
economics enables maximum flexibility in the design of heterogeneity. The artificial economy of
Agent Island is populated by many agents, and these agents might be heterogenous in many
dimensions (such as endowments, technology, tastes, behavior, etc.). We have already explained this
issue. It is the difficult task of the model design and its ‘validation’ process to find a reasonable
specifications for the heterogeneity. However, the role of heterogeneity is not as trivial as one might
expect. It is not a mere extension of the homogenous agent framework: If heterogeneous agents (e.g.
heterogenous with respect to behavior) adjust continually to the overall situation they create together,
then they adapt within an environment they created together. And in so adapting, they change that
environment (which could also be termed ‘ecology’). According to this, ‘evolution’ (in the sense of
‘evolutionary’ economics) is used in the broadest sense of the word, which can be interpreted as
elements adapting their state to the situation they together create (Arthur, 2006). We see that in this
sense our adopted framework of ‘evolutionary’ economics emerges naturally from the very
construction of the modeling in the agent–based framework. It need not be added as an adjunct.
Against the background of those explanations, it should be clear that the artificial economy of Agent
Island emerges bottom–up; it is not constructed top–down as the Robinson Crusoe economy. We start
from individual choices, whereas the latter takes as its starting point observed relations between
aggregates. In general, agent–based computational are characterized in the following way: “There is
no central, or ‘top down’, control over individual behavior in agent–based models. Of course, there
will generally be feedback between macrostructures and microstructures, as where newborn agents are
conditioned by social norms or institutions that have taken shape endogenously through earlier agent
interactions. In this sense, micro and macro will, in general, co–evolve. But as a matter of model
specification, no central controllers (e.g., Walrasian auctioneers) or higher authorities are posited ab
initio.” (Epstein, 2006b, p. 1588) Consequently, the present analysis is able to investigate the true
relationship between micro behavior and macro dynamics, which is not possible in ‘representative
agent’ models. This will ultimately enable the discussion concerning ‘fallacies of composition’.

1.3 Validation Framework

It is the main purpose of the present study to deliver a reasonable validated macroeconomic model.
‘Validity’ is thereby the key property of an agent–based simulation model (Kl¨ugl, 2008b). It means
that the ‘right’ model is used with respect to the intention of the researcher (Balci, 1994). Hence,
validity of an agent–based model is necessary for any normative analysis: A valid model produces
reliable results, and only a valid model is able to answer questions directed at the original system.
Therefore, ‘validation’ can be defined as “the process of determining whether a simulation model is
an accurate representation of the system, for the particular objectives of the study” (Law, 2005, p. 24).
In general, there exists a variety of ‘validation’ types. For example ‘validation’ can be empirical, or
statistical; ‘validation’ can cover the theory, the conceptional model, or the program code, and so
on.26 In this study we follow the ‘validation’ approach suggested by Kl¨ugl (Kl¨ugl, 2008a; Kl¨ugl,
2008b), which is developed in the field of computer science. Figure 1.2 illustrates the framework of
this approach.

1.3.1 Conceptual Model

The basic building block of an agent–based simulation is the ‘conceptual model’. Constructing an
ACE model gives the researcher a sense of playing God in his own artificial world. As explained
throughout section 1.1, the researcher has to define a number of agents with characteristic variables, a
set of decision rules or routines, and an environment in which interaction takes place. Those
definitions are constituted in the ‘conceptual model’. In case of the presented model, the programing
took place in the SeSAm programing environment.

1.3.2 Face Validation

The ‘validation’ process described in figure 1.2 starts with a run–able model. This implies that
simulation output can be generated through simulation runs. It is important to note that this does not
mean that ‘validation’ is irrelevant in earlier phases of the model development. In fact, the opposite is
true: If not, at first, the conceptual ‘validation’ is considered, the subsequent steps considered in the
‘validation’ framework do not make sense (Kl¨ugl, 2008b). We define ‘face validation’ in accordance
to (Kl¨ugl, 2008b, p. 3): “All tests based on reviews, audits, involving presentation and justification of
assumptions and model structure are used for reaching this form of plausibility”.

1.3.3 Sensitivity Analysis

Within the present framework depicted in figure 1.2 the results of the sensitivity analysis delivers a
minimal model to be investigated in the further ‘validation’ process. This implies that parameters
without significant impact on model output drop out from further investigations. Equally important,
the sensitivity analysis is used to verify the assumed relationships between micro parameters and
macro output. Accordingly, we use the sensitivity analysis to develop a basic understanding of our
simulation model (Kleijnen et al., 2003). In this context the present subsection should give some basic
methodological guidelines for a sensitivity analysis and computer experiments. The latter is
necessary, because the data used in the sensitivity analysis are generated through computer
experiments. Hence, we need to discuss some basics in ‘experimental design’ (usually termed ‘Design
of Experiments’, or DoE in brief) as well.

1.4 Conclusion
This section explains several basic aspects of agent–based computational economics. It should
become clear:
1. What elements an agent–based model must contain;
2. For what reasons a researcher may prefer agent–based computational simulation technique
over the orthodox framework;
3. How a reasonable validated agent–based macroeconomic model can be obtained. According
to that, we have a starting point for the following chapters. There, the conceptual model will be
illustrated in detail, and the ‘validation’ procedure of the model will be discussed.
Chapter 2. Conceptual Model of Agent Island
This chapter describes a monetary macro model developed in an agent–based environment, and
furthermore presents a road map for the design of such a model. As one major aim of this study is to
deliver a first agent–based simulation approach in the field of monetary macroeconomics, the model
features some monetary aspects that are new in agent–based research, e.g. nominal prices, inflation,
financial assets as well as the central bank. The central bank agent sets nominal interest rates, in order
to control output and inflation in analogy to the simplified situation in the real world. From this
perspective the model pertains to the field of monetary theory. In the following description we present
all relevant components of the model, so that the reader gets an idea of the model itself, but also how
to design an agent–based monetary macro model. We will see through this conceptual model that
some pitfalls can occur in developing such a model: The implementation of the monetary circuit and
the financial system is easily done, but how to deal with problems of large inflation and deflation is
yet more complex. We will address these topics respectively during the next two chapters. Some of
these problems may appear strange to economists unfamiliar with the agent–based technique.
However, they have to be tackled, when one tries to validate such a model. The description of this
chapter therefore gives some guidelines pertaining to further research in this field.
2.1 Overview The structure of the economy of Agent Island is straightforward. It
contains two main economic sectors including private households and firms; the firm sector is
consisting of three subsectors (hash, bean and capital firms), and each of the sectors (or subsectors)
comprises agents, which can be heterogenous or homogenous. Hence, the model is composed of: (i)
consumers, (ii) hash firms, (iii) bean firms, and (iv) capital firms.

2.1.1 Theoretical Roots and Antecedents

The summary of this subsection highlights only some basic links to literature. It is thus a mere
introduction to the underlying literature of the present model—detailed links to literature are
presented in the following section. In general, it is complex and difficult to develop an agent–based
macro model. One difficulty is due to the fact that unlike in ‘orthodox’ macroeconomics, until now no
single accepted methodology exists in the agent–based framework.

2.1.2 Markets, Transactions and Financing Contracts

Before turning to the detailed description of the model we want to give a general overview of the
sectors (subsectors) and their interactions. First, figure 2.1 presents an overview of transactions in the
model, whereby the figure depicts only monetary streams, but not the opposite streams of real goods
and services. It should be noted that all real transactions within the model are immediately settled
through bank accounts at the ‘mono–bank’. Additionally, for households the terms (i) ‘expenses’
(‘proceeds’), (ii) ‘expenditures’ (‘receipts’), and (iii) ‘disbursement’ (‘payment’) have the same
meaning, and we use them as synonyms.8 In the following we will concentrate on the system of
receipts and expenditures in the agent economy, and for household agents we will also use the term
‘income’ analogical to ‘receipts’. Finally, for any agent in the model we do not differentiate between
receipts and payments, i.e. financial assets and money are the same.

2.2 Model of Agent Island

This section gives a detailed description of the conceptual model of the economy of Agent Island and
of the process that leads to the development of the given design. Consequently, we make several
references to the ‘face validation’ of the model, which takes up a prominent part within the overall
‘validation’. In the case of the present model, this stage of the project lasted about several months.
Next to the intensive discussion of the micro structure, the final subsections 2.2.4 and 2.2.5
summarize the main macro aspects of the model. We use this macro structure in chapter 3 when
validating Agent Island. The interested reader can investigate the programed model developed in the
SeSAm software environment. See the CD in appendix C for the the installation suite needed to
implement and run the model.
2.2.1 Households
According to the scheduling of decisions, explained in the last section, it becomes apparent that
household agents make their decisions after firms. Nevertheless, the decisions of household agents are
central to the model and rather complex. Therefore, we start with analyzing the household sector.
During the simulation, private household agents face two decisions: (i) The decision of dividing
present disposable income (or better receipts) into consumption expenditures and financial savings.
(ii) Furthermore, they choose to allocate the consumption expenditures to several goods.
Consequently, an agent can choose how much income he would like to save in one risk–less financial
asset and how much income (or wealth) he should spend to buy consumption goods. We should bear
in mind that individual savings behavior should be linked to interest rate movements. This is one
implication of the macro bindings of Agent Island (see section 1.3), as it is our aim to implement
monetary transmission channels into the model. This implies a reaction of individual savings behavior
to the interest rate policy of the central bank.

2.2.2 Consumer Goods Firms and Markets

We assume that the consumption goods market is competitive, i.e. that it is populated by a large
number of firms, which supply consumption goods. The design of these consumer goods firms
follows the proposal of Axel Leijonhufvud, 2006a. Based upon the ‘theory of complex systems’,
Leijonhufvud’s model introduces the seminal notion of Alfred Marshall into the field of agent–based
macroeconomics. Marshall designs the behavior of firms in an adaptive manner, which can be
described adequately by difference equations. The combination of several of such difference
equations make the system highly non–linear and therefore complex. In Marshall’s time, the
analytical techniques to handle such systems were not available (Leijonhufvud, 2006a). Nowadays,
with the development of advanced programing languages and increasing computing power, it is
possible to handle such non–linear ‘complex systems’.