IDEAS home Printed from https://ideas.repec.org/a/fip/fedgpr/y2005p17-38.html
   My bibliography  Save this article

Certainty equivalence and model uncertainty

Author

Listed:
  • Lars Peter Hansen
  • Thomas J. Sargent

Abstract

Simon?s and Theil?s certainty equivalence property justifies a convenient algorithm for solving dynamic programming problems with quadratic objectives and linear transition laws: first, optimize under perfect foresight, then substitute optimal forecasts for unknown future values. A similar decomposition into separate optimization and forecasting steps prevails when a decision maker wants a decision rule that is robust to model misspecification. Concerns about model misspecification leave the first step of the algorithm intact and affect only the second step of forecasting the future. The decision maker attains robustness by making forecasts with a distorted model that twists probabilities relative to his approximating model. The appropriate twisting emerges from a two-player zero-sum dynamic game.

Suggested Citation

  • Lars Peter Hansen & Thomas J. Sargent, 2005. "Certainty equivalence and model uncertainty," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 17-38.
    • Handle: RePEc:fip:fedgpr:y:2005:p:17-38
    as

    Download full text from publisher

    File URL: http://www.federalreserve.gov/events/conferences/mmp2004/pdf/hansensargent.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, vol. 39(5), pages 659-681, September.
    2. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-987, December.
    3. Fudenberg, Drew & Levine, David, 1998. "Learning in games," European Economic Review, Elsevier, vol. 42(3-5), pages 631-639, May.
    4. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    5. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Permanent Income and Pricing," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 3, pages 33-81, World Scientific Publishing Co. Pte. Ltd..
    6. Philippe Weil, 1993. "Precautionary Savings and the Permanent Income Hypothesis," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(2), pages 367-383.
    7. Hansen, Lars Peter & Sargent, Thomas J. & Wang, Neng E., 2002. "Robust Permanent Income And Pricing With Filtering," Macroeconomic Dynamics, Cambridge University Press, vol. 6(1), pages 40-84, February.
    8. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    9. Drew Fudenberg & David K. Levine, 1998. "The Theory of Learning in Games," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061945, April.
    10. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Gavin, William T. & Keen, Benjamin D. & Pakko, Michael R., 2009. "Inflation Risk And Optimal Monetary Policy," Macroeconomic Dynamics, Cambridge University Press, vol. 13(S1), pages 58-75, May.
    2. Brock, William A. & Durlauf, Steven N. & West, Kenneth D., 2007. "Model uncertainty and policy evaluation: Some theory and empirics," Journal of Econometrics, Elsevier, vol. 136(2), pages 629-664, February.
    3. Raghu Suryanarayanan, 2006. "A Model of Anticipated Regret and Endogenous Beliefs," CSEF Working Papers 161, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 01 Dec 2008.
    4. Yongyang Cai & Kenneth Judd & Jevgenijs Steinbuks, 2017. "A nonlinear certainty equivalent approximation method for dynamic stochastic problems," Quantitative Economics, Econometric Society, vol. 8(1), pages 117-147, March.
    5. Raghu Suryanarayanan, 2006. "Implications of Anticipated Regret and Endogenous Beliefs for Equilibrium Asset Prices: A Theoretical Framework," CSEF Working Papers 162, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Lars Peter Hansen & Thomas J. Sargent, 2001. "Acknowledging Misspecification in Macroeconomic Theory," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(3), pages 519-535, July.
    2. Luo, Yulei & Young, Eric R., 2016. "Induced uncertainty, market price of risk, and the dynamics of consumption and wealth," Journal of Economic Theory, Elsevier, vol. 163(C), pages 1-41.
    3. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414, National Bureau of Economic Research, Inc.
    4. Yulei Luo & Eric R. Young, 2010. "Risk-Sensitive Consumption and Savings under Rational Inattention," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(4), pages 281-325, October.
    5. Luo, Yulei & Nie, Jun & Young, Eric R., 2012. "Robustness, information–processing constraints, and the current account in small open economies," Journal of International Economics, Elsevier, vol. 88(1), pages 104-120.
    6. Luo, Yulei & Young, Eric, 2013. "Consumption, Market Price of Risk, and Wealth Accumulation under Induced Uncertainty," MPRA Paper 50998, University Library of Munich, Germany.
    7. Lars Peter Hansen & Thomas J Sargent, 2014. "Doubts or Variability?," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 7, pages 217-256, World Scientific Publishing Co. Pte. Ltd..
    8. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Permanent Income and Pricing," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 3, pages 33-81, World Scientific Publishing Co. Pte. Ltd..
    9. Yulei Luo, 2005. "Consumption Dynamics, Asset Pricing, and Welfare Effects under Information Processing Constraints," 2005 Meeting Papers 345, Society for Economic Dynamics.
    10. Raghu Suryanarayanan, 2006. "Implications of Anticipated Regret and Endogenous Beliefs for Equilibrium Asset Prices: A Theoretical Framework," CSEF Working Papers 162, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    11. Kyle Jurado, 2016. "Advance Information and Distorted Beliefs in Macroeconomic and Financial Fluctuations," 2016 Meeting Papers 154, Society for Economic Dynamics.
    12. So, Leh-chyan, 2013. "Are Real Options “Real”? Isolating Uncertainty from Risk in Real Options Analysis," MPRA Paper 52493, University Library of Munich, Germany.
    13. Wang, Chong & Wang, Neng & Yang, Jinqiang, 2016. "Optimal consumption and savings with stochastic income and recursive utility," Journal of Economic Theory, Elsevier, vol. 165(C), pages 292-331.
    14. Michael Paetz, 2007. "Robust Control and Persistence in the New Keynesian Economy," Quantitative Macroeconomics Working Papers 20711, Hamburg University, Department of Economics.
    15. Yoo, Seung Han, 2014. "Learning a population distribution," Journal of Economic Dynamics and Control, Elsevier, vol. 48(C), pages 188-201.
    16. Luo, Yulei & Nie, Jun & Young, Eric R., 2014. "Robust control, informational frictions, and international consumption correlations," European Economic Review, Elsevier, vol. 67(C), pages 1-27.
    17. Dennis, Richard, 2014. "Imperfect credibility and robust monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 44(C), pages 218-234.
    18. Abdelhak S. Senhadji, 2000. "How Significant are Departures from Certainty Equivalence? Some Analytical and Empirical Results," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 597-617, July.
    19. Isaac Kleshchelski & Nicolas Vincent, 2007. "Robust Equilibrium Yield Curves," Cahiers de recherche 08-02, HEC Montréal, Institut d'économie appliquée.
    20. Miles Kimball & Philippe Weil, 2009. "Precautionary Saving and Consumption Smoothing across Time and Possibilities," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(2‐3), pages 245-284, March.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedgpr:y:2005:p:17-38. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Ryan Wolfslayer ; Keisha Fournillier (email available below). General contact details of provider: https://edirc.repec.org/data/frbgvus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.