Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Doubts or Variability?

November 2009
Francisco Barillas, Lars Peter Hansen, Thomas J. Sargent

Reinterpreting most of the market price of risk as a price of model uncertainty eradicates a link between asset prices and measures of the welfare costs of aggregate fluctuations that was proposed by Hansen, Sargent, and Tallarini [17], Tallarini [30], Alvarez and Jermann [1]. Prices of model uncertainty contain information about the benefits of removing model uncertainty, not the consumption fluctuations that Lucas [22] and [23] studied. A max–min expected utility theory lets us reinterpret Tallarini's risk-aversion parameter as measuring a representative consumer's doubts about the model specification. We use model detection instead of risk-aversion experiments to calibrate that parameter. Plausible values of detection error probabilities give prices of model uncertainty that approach the Hansen and Jagannathan [11] bounds. Fixed detection error probabilities give rise to virtually identical asset prices as well as virtually identical costs of model uncertainty for Tallarini's two models of consumption growth.

Publication Type: 
Article
Journal: 
Journal of Economic Theory
Volume: 
144
Issue Number: 
6
Pages: 
2388-2418