The Imperfect Knowledge Imperative in Modern Macroeconomics and Finance Theory

2013 ◽  
Author(s):  
Roman Frydman ◽  
Michael D. Goldberg
Keyword(s):  
Behavioral Finance ◽  
Real World ◽  
Rational Expectations ◽  
Individual Behavior ◽  
Expectations Hypothesis ◽  
Alternative Approach ◽  
World Markets ◽  
Imperfect Knowledge ◽  
Finance Theory ◽  
Imperfect Knowledge Economics

This chapter examines the imperfect knowledge imperative in modern macroeconomics and finance theory. It argues that the Rational Expectations Hypothesis (REH) has nothing to do with how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. It attributes REH's insurmountable epistemological difficulties and widespread empirical problems to a single, overarching premise that underpins contemporary macroeconomics and finance theory: nonroutine change is unimportant for understanding outcomes. It also suggests that contemporary behavioral finance models rest on the same core premise as their REH-based counterparts. Finally, it introduces an alternative approach to modeling individual behavior and aggregate outcomes: Imperfect Knowledge Economics, which opens macroeconomics and finance models to nonroutine change and the imperfect knowledge that it engenders.

scholarly journals TESTING RATIONAL EXPECTATIONS HYPOTHESIS IN THE MANUFACTURING SECTOR IN MALAYSIA

2013 ◽  
Vol 14 (2) ◽  
pp. 303-316 ◽  
Author(s):  
Chin-Hong Puah ◽  
Shirly Siew-Ling Wong ◽  
Venus Khim-Sen Liew
Keyword(s):  
Empirical Evidence ◽  
Real World ◽  
Rational Expectations ◽  
Manufacturing Sector ◽  
Relevant Information ◽  
Manufacturing Firms ◽  
Capital Expenditures ◽  
Expectations Hypothesis ◽  
The World ◽  
Economic Thinking

The application of rational expectations hypothesis (REH) in macroeconomic research has marked a revolution in economic thinking, and the magnitude of its impact on the world of economics is undeniably significant. However, the extent to which REH applies in real-world settings is ambiguous even though the concept of REH is well established in economics literature because empirical evidence from previous studies is clearly mixed. This study used survey data on gross revenue and capital expenditures to examine the validity of REH in Malaysian manufacturing business expectations. Empirical results indicated that the manufacturers’ expectations are being irrationally constructed in terms of gross revenue predictions but comply with REH properties in Muth's sense in the case of capital expenditures forecasts. Therefore, manufacturing firms in Malaysia are encouraged to incorporate more relevant information into their gross revenue predictions to provide more accurate and realistic forecasting.

scholarly journals Which Way Forward for Macroeconomics and Policy Analysis?

2013 ◽  
Author(s):  
Roman Frydman ◽  
Edmund S. Phelps
Keyword(s):  
Economic Analysis ◽  
Policy Analysis ◽  
Asset Prices ◽  
Rational Expectations ◽  
Market Volatility ◽  
Natural Rate ◽  
Expectations Hypothesis ◽  
Natural Rate Of Unemployment ◽  
Imperfect Knowledge

This introductory chapter discusses the papers presented at the Center on Capitalism and Society conference held in the fall of 2010. The conference, which commemorated the fortieth anniversary of the Phelps microfoundations volume, featured researchers engaged in developing alternatives to the Rational Expectations Hypothesis (REH). The Phelps volume provided radically new accounts of the comovements of macroeconomic aggregates, including inflation and unemployment, while casting serious doubt on the validity of policy analysis based on then-popular Keynesian macroeconometric models. This chapter considers the various efforts to reinvent macroeconomics that were discussed at the Phelps conference, with a particular focus on non-REH alternatives and their implications for economic analysis. Topics include nonroutine change and imperfect knowledge, expectational coordination and market volatility, autonomous expectations in long swings in asset prices, and the natural rate of unemployment.

Behavioral Finance in Theory and Practice

2014 ◽  
pp. 254-271
Author(s):  
Mustafa Okur ◽  
A. Osman Gurbuz
Keyword(s):  
Financial Markets ◽  
Behavioral Finance ◽  
Psychological Factors ◽  
Rational Expectations ◽  
Main Idea ◽  
Efficient Market Hypothesis ◽  
Theory And Practice ◽  
Efficient Market ◽  
New Approach ◽  
Finance Theory

Behavioral finance is a new approach in finance literature. The main idea is that investors are not as rational as they are assumed to be. Therefore, financial markets could be better understood by using models that capture the effects of both rational and irrational investors. The critics of behavioral finance could be grouped into two main categories: limits of arbitrage and psychological factors. This chapter concentrates on both challenges and possible contributions of behavioral finance theory to the modern finance theory, which is mainly based on rational expectations theory and efficient market hypothesis.

Opening Models of Asset Prices and Risk to Nonroutine Change

2013 ◽  
Author(s):  
Roman Frydman ◽  
Michael D. Goldberg
Keyword(s):  
Economic Policy ◽  
Social Context ◽  
Asset Prices ◽  
Financial Risk ◽  
Asset Price ◽  
Decision Rules ◽  
Alternative Approach ◽  
The Social ◽  
Imperfect Knowledge ◽  
Imperfect Knowledge Economics

This chapter considers an alternative approach to economic analysis, Imperfect Knowledge Economics (IKE), and introduces a model of asset prices and risk that has explicit mathematical microfoundations and yet remains open to nonroutine change. The IKE model consists of representations of individuals' preferences, forecasting behavior, constraints, and decision rules in terms of a set of causal (often called “informational”) variables, which portray the influence of economic policy, institutions, and other features of the social context. It also entails an aggregation rule and processes for the informational variables. The chapter examines irregular swings in asset prices and their relationship to financial risk. It also presents an IKE account of asset price swings before concluding with an analysis of contingent predictions of long swings and their compatibility with rationality.

Behavioral Finance in Theory and Practice

2014 ◽  
pp. 311-328
Author(s):  
Mustafa Okur ◽  
A. Osman Gurbuz
Keyword(s):  
Financial Markets ◽  
Behavioral Finance ◽  
Psychological Factors ◽  
Rational Expectations ◽  
Main Idea ◽  
Efficient Market Hypothesis ◽  
Theory And Practice ◽  
Efficient Market ◽  
New Approach ◽  
Finance Theory

Behavioral finance is a new approach in finance literature. The main idea is that investors are not as rational as they are assumed to be. Therefore, financial markets could be better understood by using models that capture the effects of both rational and irrational investors. The critics of behavioral finance could be grouped into two main categories: limits of arbitrage and psychological factors. This chapter concentrates on both challenges and possible contributions of behavioral finance theory to the modern finance theory, which is mainly based on rational expectations theory and efficient market hypothesis.

scholarly journals Rethinking the Role of the Representativeness Heuristic in Macroeconomics and Finance Theory

2020 ◽  
pp. 1-42
Author(s):  
Roman Frydman ◽  
Morten Nyboe Tabor
Keyword(s):  
Behavioral Finance ◽  
Rational Expectations ◽  
Behavioral Models ◽  
Macroeconomic Models ◽  
Representativeness Heuristic ◽  
Finance Theory ◽  
Empirical Foundation

We propose a novel interpretation and formalization of Kahneman and Tversky's findings in the Linda experiment which implies that subjects are rational in the sense of Muth's hypothesis and provides an approach to specifying rational assessment of uncertainty in macroeconomic models. Behavioral-finance theorists have appealed to Kahneman and Tversky's findings as an empirical foundation for a general approach replacing rational expectations. We show that behavioral models' specifications of participants' irrational forecasts and predictable errors are incompatible with Kahneman and Tversky's findings. Our interpretation of Kahneman and Tversky's findings is supportive of Lucas's compelling critique of inconsistent macroeconomic models.

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