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UNCERTAINTY WITHIN ECONOMIC MODELS 9028_9789814578110_tp.indd 1 9/7/14 8:40 am 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 NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TAIPEI • CHENNAI 9028_9789814578110_tp.indd 2 9/7/14 8:40 am Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE 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, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. In-house Editor: Alisha Nguyen Typeset by Stallion Press Email: [email protected] Printed in Singapore Alisha - Uncertainty within Economic Models.indd 2 24/7/2014 1:25:46 PM July25,2014 14:40 UncertaintywithinEconomicModels-9inx6in b1808-fm pagev To David Jacobson and Peter Whittle v May2,2013 14:6 BC:8831-ProbabilityandStatisticalTheory PST˙ws TThhiiss ppaaggee iinntteennttiioonnaallllyy lleefftt bbllaannkk July25,2014 14:40 UncertaintywithinEconomicModels-9inx6in b1808-fm pagevii 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 vii May2,2013 14:6 BC:8831-ProbabilityandStatisticalTheory PST˙ws TThhiiss ppaaggee iinntteennttiioonnaallllyy lleefftt bbllaannkk July25,2014 14:40 UncertaintywithinEconomicModels-9inx6in b1808-fm pageix 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. ix