ABSTRACT: Two agents trade an indivisible
asset. They are risk neutral and share a common benchmark dividend model.
However, each has doubts about the specification of this model. These doubts manifest themselves as a preference for
robustness (Hansen and Sargent (2008)). Robust preferences introduce pessimistic drift distortions into the benchmark
dividend process. These distortions increase with the level of wealth, and give rise to endogenous heterogeneous beliefs.
Belief heterogeneity allows asset price bubbles to emerge, as in Scheinkman and Xiong (2003). A novel implication of
our analysis is that bubbles occur when wealth inequality increases. Empirical evidence supports this prediction. Detection
error probabilities suggest that the implied degree of belief heterogeneity is empirically plausible.
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.
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.