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The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth`s Consistency Constraint in Modeling Aggregate Outcomes

Author

Listed:
  • Roman Frydman

    (New York University)

  • Soren Johansen

    (University of Copenhagen)

  • Anders Rahbek

    (University of Copenhagen)

  • Morten Tabor

    (University of Copenhagen)

Abstract
This paper introduces the Knightian Uncertainty Hypothesis (KUH), a new approach to macroeconomics and finance theory. KUH rests on a novel mathematical framework that characterizes both measurable and Knightian uncertainty about economic outcomes. Relying on this framework and John Muth`s pathbreaking hypothesis, KUH represents participants`forecasts to be consistent with both uncertainties. KUH thus enables models of aggregate outcomes that 1) are premised on market participants` rationality, and 2) yet accord a role to both fundamental and psychological (and other non-fundamental) factors in driving outcomes. The paper also suggests how a KUH model`s quantitative predictions can be confronted with time series data.

Suggested Citation

  • Roman Frydman & Soren Johansen & Anders Rahbek & Morten Tabor, 2019. "The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth`s Consistency Constraint in Modeling Aggregate Outcomes," Working Papers Series 92, Institute for New Economic Thinking.
  • Handle: RePEc:thk:wpaper:92
    DOI: 10.2139/ssrn.3346766
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    References listed on IDEAS

    as
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    2. Annalisa Cristini & Piero Ferri, 2021. "Nonlinear models of the Phillips curve," Journal of Evolutionary Economics, Springer, vol. 31(4), pages 1129-1155, September.
    3. Matthias J. Feiler & Thibaut Ajdler, 2019. "Model uncertainty in financial forecasting," Papers 1912.10813, arXiv.org.

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    More about this item

    Keywords

    Unforeseeable Change; Knightian Uncertainty; Muth`s Hypothesis; Model Ambiguity; REH; Behavioral Finance;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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