Uncertainty within Economic Models

483 Pages·2014·3.132 MB·English

by  Lars Peter Hansen, Thomas J Sargent

UNCERTAINTY
WITHIN ECONOMIC
MODELS
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World Scientific Series in Economic Theory
(ISSN: 2251-2071)
Series Editor: Eric Maskin (Harvard University, USA)

Published
Vol. 1 Equality of Opportunity: The Economics of Responsibility
by Marc Fleurbaey and François Maniquet
Vol. 2 Robust Mechanism Design: The Role of Private Information and
Higher Order Beliefs
Dirk Bergemann and Stephen Morris
Vol. 3 Case-Based Predictions: An Axiomatic Approach to Prediction,
Classification and Statistical Learning
Itzhak Gilboa and David Schmeidler
Vol. 4 Simple Adaptive Strategies: From Regret-Matching to
Uncoupled Dynamics
Sergiu Hart and Andreu Mas-Colell
Vol. 5 The Language of Game Theory: Putting Epistemics into the Mathematics
of Games
Adam Brandenburger
Vol. 6 Uncertainty within Economic Models
Lars Peter Hansen and Thomas J Sargent
Forthcoming
Decision Theory
Wolfgang Pesendorfer (Princeton University, USA) &
Faruk Gul (Princeton University, USA)
Leverage and Default
John Geanakoplos (Yale University, USA)
Leverage Cycle, Equilibrium and Default
Vol. 2: Collateral Equilibrium and Default
John Geanakoplos (Yale University, USA)
Learning and Dynamic Games
Dirk Bergemann (Yale University, USA) & Juuso Valimaki (Aalto University, Finland)
Alisha - Uncertainty within Economic Models.indd 1 24/7/2014 1:25:46 PM
World Scientific Series in Economic Theory – Vol. 6
UNCERTAINTY
WITHIN ECONOMIC
MODELS
Lars Peter Hansen
University of Chicago, USA
Thomas J Sargent
New York University, USA & Hoover Institution, USA
World Scientific
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Library of Congress Cataloging-in-Publication Data
Hansen, Lars Peter.
Uncertainty within economic models / by Lars Peter Hansen (University of Chicago, USA &
The National Bureau of Economic Research, USA) and Thomas J Sargent (New York University,
USA & Hoover Institution, USA). -- 1 Edition.
pages cm. -- (World scientific series in economic theory ; 6)
Includes bibliographical references and index.
ISBN 978-9814578110 (hardcover) -- ISBN 9814578118 (hardcover)
1. Economics--Mathematical models. I. Sargent, Thomas J. II. Title.
HB135.H368 2014
330.01'5195--dc23
2014017341
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library.
Copyright © 2015 by World Scientific Publishing Co. Pte. Ltd.
All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means,
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In-house Editor: Alisha Nguyen
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Printed in Singapore
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To David Jacobson and Peter Whittle
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Foreword
Assuming “rational expectations” — that agents within a model and the
econometricianobservingthoseagentshavespecifiedthemodelcorrectly—
has proved to be an extraordinarily useful approach to macroeconomics,
and Lars Hansen and Thomas Sargent have been in the vanguard of that
approach. But Hansen and Sargent have also led the way in showing how
departures from rational expectations — specifically, the possibility of
model misspecification — can fruitfully be studied by macroeconomists.
In this volume, Hansen and Sargent have assembled ten fundamental
articles on how to proceed when agents and econometricians are uncertain
about the correct model. Nine of the ten are joint work (sometimes with
additional authors);one is by Hansen alone.Hansen andSargenthavealso
written an introduction that lays out how they deal with misspecification
in general and what the individual papers do in particular.
I am extremely grateful to Lars Hansen and Thomas Sargent for pro-
ducing this important book. The profession will be grateful to them too.
Eric Maskin
Editor-in-Chief
World Scientific Series in Economic Theory
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Preface
We have devoted large parts of our professional lives to refining and
applying rational expectations macroeconomics and econometrics. This
book describes some of our recent efforts to come to grips with
misspecification about and within economic models, a problem that the
rational expectations assumption ignores.
Rational expectations is a powerful device for restricting data. It
eliminatesallfreeparametersdescribingbeliefsaboutendogenousoutcomes
andimposesapervasive“communismofbeliefs”amongallagentswithina
model, the outside observers and econometricians estimating the model,
and the “god” or “nature” that generates the actual data. Applied
researchersexploitthatcommunismofbeliefsbothincomputingarational
expectations equilibrium and in constructing good statistical estimators
based on likelihood functions and other moment matching methods.
Thirty five years of applying rational expectations econometrics
delivered its share of disappointments and “creative destructions.” The
cross-equation restrictions that are a hall mark of rational expectations
modelshaveoftengeneratedconvincingempiricalevidenceagainstavariety
ofex antebeautifultheoreticalmodels.Oneconstructiveresponsehasbeen
to sort through the wreckage left by those likelihood ratios and related
statisticaltestsinsearchofdiagnosticsthathintatimprovedspecifications
of the preferences, technologies, timing protocols, and information flows
that comprise the elements of a rational expectations model.
There have been other sensible responses. Our good friend Robert
E. Lucas, Jr. told us in the early 1980s that our likelihood ratio tests and
moment matching tests were rejecting too many good models. He went on
to say that all models are at best approximations (a polite way of saying
that they are wrong) that should be compared to the data with more
forgiving methods like the calibration techniques advocated by Kydland
and Prescott. Many macroeconomists have followed that advice.
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