Description

In many macroeconomic models today, uncertainty has only modest impacts. This is because these models embrace the assumption of rational expectations that says that people know the probabilities implied by the model. The rational expectations assumption is a valuable tool for evaluating many problems, but is dubious for analyzing many of the important situations we face today when concerns about temperatures, other physical determinants of long-term growth prospects, and demographic drivers of possible “secular stagnation” are on many peoples’ minds. Therefore, we propose to expand the usual rational expectations approach in macroeconomics by attributing uncertainty to the probabilities that people in our models are facing. We see this as having vital implications for formulating sensible economic policies. We push beyond the conventional risk-based, rational expectations analyses by probing more general paradigms coming from decision theory and modern mathematical control theory. Furthermore, we complement and extend other behavioral research that emphasizes psychological mechanisms. We accomplish this by using statistical theory to formalize how environmental complexities of the model framework can influence individual behaviors.

Related Paper: Pricing Uncertainty Induced by Climate Change by Michael Barnett, William Brock and Lars Peter Hansen