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Economic Implications of Model Uncertainty

Paper Session

Sunday, Jan. 7, 2018 10:15 AM - 12:15 PM

Marriott Philadelphia Downtown, Grand Ballroom Salon I
Hosted By: American Economic Association
  • Chair: Stephen Morris, Princeton University

Dampening General Equilibrium: From Micro to Macro

George-Marios Angeletos
,
Massachusetts Institute of Technology
Chen Lian
,
Massachusetts Institute of Technology

Abstract

Abstract We argue that standard modeling practices often overstate the potency of general-equilibrium (GE) mechanisms. We formalize the notion that GE adjustment is weak, or that it takes time, by modifying an elementary Walrasian economy in two alternative manners. In one, we replace Rational Expectations Equilibrium with solution concepts that mimic Tâtonnement or Cobweb dynamics, Level-k Thinking, Reflective Equilibrium, and certain kinds of cognitive discounting. In the other, we maintain rational expectations but remove common knowledge of aggregate shocks and accommodate higher-order uncertainty. This permits us, not only to illustrate the broader plausibility of the notion that the GE adjustment may be weak or slow, but also to illustrate the sense in which our preferred approach—the one based on lack of common knowledge—can be seen as a disciplined substitute to certain kinds of bounded rationality. We finally discuss possible applications, including how our results may help reduce the gap between the macroeconomic effects of interest and the micro or local effects estimated in a growing empirical literature.

The Tail that Wags the Economy: Beliefs and Persistent Stagnation

Julian Julian Kozlowski
,
New York University
Laura Veldkamp
,
New York University
Venky Venkateswaran
,
New York University

Abstract

The Great Recession was a deep downturn with long-lasting eects on credit markets, labor markets and output. While narratives about what caused the recession abound, the persistence of GDP below its pre-crisis trend is puzzling. We propose a simple persistence mechanism that can be easily quantified and combined with existing models, even complex ones. Our solution rests on the premise that no one knows the true distribution of shocks to the economy. If agents use observed macro data to estimate this distribution non-parametrically, then transitory events, especially extreme events, generate persistent changes in beliefs and thus in macro outcomes. We apply our tool to an existing model, designed to explain the onset of the great recession, and find that adding belief updating endogenously generates the persistence of the downward shift in US output, colloquially known as "secular stagnation."

Games of Incomplete Information Played by Statisticians

Annie Liang
,
University of Pennsylvania

Abstract

The common prior assumption is a convenient restriction on beliefs in games of incomplete information, but conflicts with evidence that players publicly disagree in many economic environments. This paper proposes a foundation for heterogeneous beliefs in games, in which disagreement arises not from different information, but from different interpretations of common information. A key assumption imposes that while players may interpret data in different ways,
they have common certainty in the predictions induced by a class of interpretations.
The main results characterize which rationalizable actions and Nash equilibria can be predicted when agents observe a finite quantity of data, and how much data is needed to predict different solutions. This quantity, which I refer to as the robustness of the solution, is shown to depend crucially on the degree of strictness of the solution and the "complexity" of inference from data.

Crises: Equilibrium Shifts and Large Shocks

Muhamet Yildiz
,
Massachusetts Institute of Technology
Stephen Morris
,
Princeton University

Abstract

A coordination game with incomplete information is played through time. In each period, payoffs depend on a fundamental state and an additional idiosyncratic shock. Fundamentals evolve according to a random walk where the changes in fundamentals (namely common shocks) have a fat-tailed distribution. We show that majority play shifts either if fundamentals reach a critical threshold or if there are large common shocks, even before the threshold is reached. The fat-tails assumption matters because it implies that large shocks make players more unsure about whether their payoffs are higher than others. This feature is necessary for large shocks to matter.
JEL Classifications
  • D8 - Information, Knowledge, and Uncertainty
  • E3 - Prices, Business Fluctuations, and Cycles