Opening Models of Asset Prices and Risk to Nonroutine Change

Abstract

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.

Change and expectations in macroeconomic models: recognizing the limits to knowability

“…In Frydman and Goldberg (2013c) and Frydman, Goldberg, Juselius, and Johansen (2013), we formalize this qualitative regularity in the context of the equity and currency markets, respectively. We show that an asset-price swing arises during stretches of time in which (a) market participants on the whole revise their forecasting strategies in guardedly moderate ways and (b) the fundamental factors that they consider relevant in driving outcomes tend to trend in unchanging directions.…”

“…The qualitative and contingent predictions generated by our IKE model of asset-price swings in Frydman and Goldberg (2013c) exemplify what Popper would regard as a feasible goal of economic theory. Although our model predicts that, under 'certain conditions,' an asset price will undergo a sustained movement in one direction, it does not predict when such upswings or downswings will begin or end.…”

“…As Dow (2013) points out, Keynes believed that social conventions imparted some regularity to individual behavior that can be exploited in economic analysis. See Frydman and Goldberg (2013c) for an example of how formalizing one such convention in modeling forecast revisions leads to persistent swings in asset markets. 12.…”

2. Learning as a Rational Foundation for Macroeconomics and Finance

“…We now outline approaches that incorporate these points. Frydman and Goldberg (2010a) describe rational expectations models as "fully predetermined models" and also group the learning approach in the same camp. We feel this is misleading.…”

“…Frydman and Goldberg (2010b) describe the application of this approach to account for persistence and long swings in asset prices and exchange rates. It is difficult to assess their approach (presented in their section 6.2) since several key aspects are purposely only loosely specified.…”