Model Uncertainty, State Uncertainty, and State-Space Models

Federal Reserve Bank of Kansas City Working Paper No. 12-02

25 Pages Posted: 20 Apr 2012

See all articles by Yulei Luo

Yulei Luo

University of Hong Kong

Jun Nie

Federal Reserve Bank of Kansas City

Eric R. Young

University of Virginia

Date Written: February 1, 2012

Abstract

State-space models have been increasingly used to study macroeconomic and financial problems. A state-space representation consists of two equations, a measurement equation which links the observed variables to unobserved state variables and a transition equation describing the dynamics of the state variables. In this paper, we show that a classic linear- quadratic macroeconomic framework which incorporates two new assumptions can be analytically solved and explicitly mapped to a state-space representation. The two assumptions we consider are the model uncertainty due to concerns for model misspecification (robustness) and the state uncertainty due to limited information constraints (rational inattention). We show that the state-space representation of the observable and unobservable can be used to quantify the key parameters on the degree of model uncertainty. We provide examples on how this framework can be used to study a range of interesting questions in macroeconomics and international economics.

Keywords: Robustness, Model Uncertainty, Rational Inattention, State Uncertainty, Signal

JEL Classification: C22, D81, D83

Suggested Citation

Luo, Yulei and Nie, Jun and Young, Eric R., Model Uncertainty, State Uncertainty, and State-Space Models (February 1, 2012). Federal Reserve Bank of Kansas City Working Paper No. 12-02. Available at SSRN: https://ssrn.com/abstract=2042727 or http://dx.doi.org/10.2139/ssrn.2042727

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

Jun Nie

Federal Reserve Bank of Kansas City ( email )

1 Memorial Drive
Kansas City, MO 64198
United States
(816) 881-2255 (Phone)
(816) 881-2199 (Fax)

HOME PAGE: http://homepages.nyu.edu/~jn461/research.htm

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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