ABSTRACT: A decision maker
doubts the stationarity of his environment. In response, he uses two
models, one with
time-varying parameters, and another with constant parameters. Forecasts are then based on a Bayesian Model Averaging
strategy, which mixes forecasts from the two models. In reality, structural parameters are constant, but the (unknown) true
model features expectational feedback, which the reduced form models neglect. This feedback permits fears of parameter
instability to become self-confirming. Within the context of a standard asset pricing model, we use the tools of large
deviations theory to show that even though the constant parameter model would converge to the Rational Expectations
Equilibrium if considered in isolation, the mere presence of an unstable alternative drives it out of consideration.
Risk, Uncertainty, and the Dynamics of Inequality (with Xiaowen Lei) forthcoming in Journal of Monetary Economics
ABSTRACT: This paper studies
the dynamics of wealth inequality in a continuous-time Blanchard/Yaari
model. Its key
innovation is to assume that idiosyncratic investment returns are subject to (Knightian) uncertainty. In response, agents
formulate `robust' portfolio policies (Hansen and Sargent (2008)). These policies are nonhomothetic; wealthy agents invest
a higher fraction of their wealth in uncertain assets yielding higher mean returns. This produces an endogenous feedback
mechanism that amplifies inequality. It also produces an accelerated rate of convergence, which helps resolve a puzzle recently
identified by Gabaix, Lasry, Lions, and Moll (2016). We ask the following question - Suppose the US was in a stationary
distribution in 1980, and the world suddenly became more `uncertain'. Could this uncertainty explain both the magnitude and
pace of recent US wealth inequality? Using detection error probabilities to discipline the degree of uncertainty, we conclude
that an empirically plausible increase in uncertainty can account for about half of the recent increase in top wealth shares.
A Behavioral Defense of Rational Expectations
ABSTRACT: This paper
studies decision making by agents who value optimism, but are unsure of
their environment. As in
Brunnermeir and Parker (2005), an agent's optimism is assumed to be tempered by the decision costs it imposes. As in
Hansen and Sargent (2008), an agent's uncertainty about his environment leads him to formulate `robust' decision rules. It is
shown that when combined, these two considerations can lead agents to adhere to the Rational Expectations Hypothesis.
Rather than being the outcome of the sophisticated statistical calculations of an impassive expected utility maximizer, Rational
Expectations can instead be viewed as a useful approximation in environments where agents struggle to strike a balance
between doubt and hope.