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

62 Pages Posted: 5 Mar 2019

See all articles by Roman Frydman

Roman Frydman

New York University (NYU) - Department of Economics

Soren Johansen

University of Copenhagen - Department of Economics; Aarhus University - CREATES

Anders Rahbek

University of Copenhagen - Department of Statistics and Operations Research; University of Copenhagen - Department of Economics

Morten Tabor

University of Copenhagen - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: February 26, 2019

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.

Keywords: Unforeseeable Change; Knightian Uncertainty; Muth’s Hypothesis; Model Ambiguity; REH; Behavioral Finance

JEL Classification: C02, C51, E00, D84, E00, G41

Suggested Citation

Frydman, Roman and Johansen, Soren and Rahbek, Anders and Tabor, Morten, The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth’s Consistency Constraint in Modeling Aggregate Outcomes (February 26, 2019). Institute for New Economic Thinking Working Paper Series No. 92 (2019). Available at SSRN: https://ssrn.com/abstract=3346766 or http://dx.doi.org/10.2139/ssrn.3346766

Roman Frydman (Contact Author)

New York University (NYU) - Department of Economics ( email )

19 West 4th Street
New York, NY 10012
United States

Soren Johansen

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

Aarhus University - CREATES ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

Anders Rahbek

University of Copenhagen - Department of Statistics and Operations Research

Universitetsparken 5
DK-2100
Denmark
+45 3532 0682 (Phone)

University of Copenhagen - Department of Economics

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

Morten Tabor

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

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