Posing a major challenge to economic orthodoxy, Imperfect Knowledge Economics asserts that exact models of purposeful human behavior are beyond the reach of economic analysis. Roman Frydman and Michael Goldberg argue that the longstanding empirical failures of conventional economic models stem from their futile efforts to make exact predictions about the consequences of rational, self-interested behavior. Such predictions, based on mechanistic models of human behavior, disregard the importance of individual creativity and unforeseeable sociopolitical change. Scientific though these explanations may appear, they usually fail to predict how markets behave. And, the authors contend, recent behavioral models of the market are no less mechanistic than their conventional counterparts: they aim to generate exact predictions of "irrational" human behavior. Frydman and Goldberg offer a long-overdue response to the shortcomings of conventional economic models. Drawing attention to the inherent limits of economists' knowledge, they introduce a new approach to economic analysis: Imperfect Knowledge Economics (IKE).
IKE rejects exact quantitative predictions of individual decisions and market outcomes in favor of mathematical models that generate only qualitative predictions of economic change. Using the foreign exchange market as a testing ground for IKE, this book sheds new light on exchange-rate and risk-premium movements, which have confounded conventional models for decades. Offering a fresh way to think about markets and representing a potential turning point in economics, Imperfect Knowledge Economics will be essential reading for economists, policymakers, and professional investors.
Roman Frydman is professor of economics at New York University and the coauthor or coeditor of many books, including "Individual Forecasting and Aggregate Outcomes: "Rational Expectations" Examined". Michael D. Goldberg is associate professor of economics at the University of New Hampshire. His articles on international finance and macroeconomics have appeared in "Economic Journal" and "Journal of International Money and Finance".
Foreword by Edmund S. Phelps xiii Acknowledgments xxi List of Abbreviations xxiii PART I: From Early Modern Economics to Imperfect Knowledge Economics 1 Chapter 1: Recognizing the Limits of Economists' Knowledge 3 The Overreach of Contemporary Economics 3 The Aim of This Book 6 Contemporary Models in a World of Imperfect Knowledge 8 The Non-Fully Intelligible Individual 13 IKE Models 14 IKE of Exchange Rates and Risk 20 Imperfect Knowledge and Policy Analysis 23 From Contemporary Economics to Imperfect Knowledge Economics 24 Chapter 2: A Tradition Interrupted 26 The Stranglehold of the Contemporary Approach 27 The Non-Fully Intelligible Individual in Early Modern Economics 34 Jettisoning Insights from Early Modern Analysis 38 Chapter 3: Flawed Foundations: The Gross Irrationality of "Rational Expectations" and Behavioral Models 41 Conventional and Behavioral Representations of Preferences with Uncertain Outcomes 42 Self-Interest, Social Context, and Individual Decisions 45 Individual Behavior and Aggregate Outcomes 48 From Early Modern to Phelps's Microfoundations 49 "Rational Expectations": Abandoning the Modern Research Program 49 Diversity of Forecasting Strategies: The Gross Irrationality of "Rational Expectations" 51 Inconsistency in Behavioral Models 54 Chapter 4: Reconsidering Modern Economics 58 Sharp Predictions and Fully Predetermined Representations 60 Qualitative Predictions of Change in Fully Predetermined Models 65 IKE Models of Change 66 IKE Causal-Transition Paths 70 Appendix 4.A: Fully Prespecifying Change in the Social Context 71 Appendix 4.B: Modeling Change in Outcomes with Fully Predetermined Probabilistic Rules 72 Chapter 5: Imperfect Knowledge Economics of Supply and Demand 74 Fully Predetermined Representations of Supply and Demand 76 Supply and Demand Analysis in Contemporary Models 79 History as the Future and Vice Versa 81 Supply and Demand Analysis in IKE Models 82 Irreversibility of History in IKE Models 86 PART II: "Anomalies" in Contemporary Models of Currency Markets 89 Chapter 6: The Overreach of Contemporary Models of Asset Markets 91 Describing Forecasting Behavior 92 Fully Predetermined Representations of Forecasting Strategies and Their Revisions 93 Modeling Economic Change with a Time-Invariant Structure 96 Models with Fully Predetermined Changes in Structure 101 Prespecifying Collective Beliefs in Currency Markets: Bubble Models 104 Appendix 6.A: A Conventional Macroeconomic Model 107 Chapter 7: The "Puzzling" Behavior of Exchange Rates: Lost Fundamentals and Long Swings 113 Exchange Rates and Macroeconomic Fundamentals: The Futile Search for a Fully Predetermined Relationship 114 The Exchange Rate Disconnect Puzzle: An Artifact of the Contemporary Approach 120 Macroeconomic Fundamentals over Long Horizons: Self-Limiting Long Swings 121 Can REH Models Explain Long Swings in Exchange Rates? 126 REH Bubble Models and the Pattern of Long Swings in Real World Markets 131 Lost Fundamentals and Forsaken Rationality: Behavioral Models 134 Chapter 8: "Anomalous" Returns on Foreign Exchange: Is It Really Irrationality? 138 The Record on Foreign Exchange Returns 140 An REH Risk Premium? 144 Is Irrationality the Answer? 147 The Forward-Discount "Anomaly": Another Artifact of the Contemporary Approach 151 PART III: Imperfect Knowledge Economics of Exchange Rates and Risk 153 Chapter 9: Modeling Preferences in Asset Markets: Experimental Evidence and Imperfect Knowledge 155 Prospect Theory and Speculative Decisions 159 Endogenous Loss Aversion and Limits to Speculation 167 Experimental Evidence and Behavioral Finance Models 170 Moving beyond Behavioral Finance Models 173 IKE Representations of Preferences in Asset Markets: Individual Uncertainty Premiums 176 Imperfect Knowledge and Preferences over Gambles: Endogenous Prospect Theory 179 Appendix 9.A: Limits to Speculation under Endogenous Loss Aversion 180 Chapter 10: Modeling Individual Forecasting Strategies and Their Revisions 183 Theories Consistent Expectations Hypothesis 185 IKE Representations of Revisions: An Overview 191 Trend Restriction 192 Conservative Revisions 194 Revisions of the Expected Unit Loss 197 Chapter 11: Bulls and Bears in Equilibrium: Uncertainty-Adjusted Uncovered Interest Parity 203 Momentary Equilibrium in the Foreign Exchange Market 204 Equilibrium under Risk Aversion 205 Uncertainty-Adjusted UIP 210 Chapter 12: IKE of the Premium on Foreign Exchange: Theory and Evidence 218 An IKE House Money Model: Time-Varying Preferences 220 An IKE Gap Plus Model: Autonomous Revisions in Forecasting Strategies 223 Confronting the Gap Plus and House Money Models with Time-Series Data 225 The Gap Plus Model and the Frequency of Sign Reversals 238 Avoiding the Presumption of Gross Irrationality 241 Appendix 12.A 242 Chapter 13: The Forward Discount "Anomaly": The Peril of Fully Prespecifying Market Efficiency 243 Bilson-Fama Regression and the Forward Discount "Anomaly" 245 Structural Instability of the BF Regression and the Gap Plus Model 246 BF Regression and Market Efficiency 252 Chapter 14: Imperfect Knowledge and Long Swings in the Exchange Rate 258 A Monetary Model 260 Invariant Representations and an Unbounded Swing Away from PPP 266 Fixed Policy Rules and Invariant Representations? 272 An IKE Model of Exchange Rate Swings 272 Conventional and Behavioral Views of Reversals 278 Imperfect Knowledge and Self-Limiting Long Swings 279 Appendix 14.A: Solution with an Invariant Representation 283 Appendix 14.B: Exchange Rate Swings and Sticky Goods Prices 283 Chapter 15: Exchange Rates and Macroeconomic Fundamentals: Abandoning the Search for a Fully Predetermined Relationship 292 Structural Change in the Causal Mechanism 295 Macroeconomic Fundamentals and the Exchange Rate in the 1970s 297 Are the Monetary Models Consistent with Empirical Evidence? 304 Macroeconomic Fundamentals and the Exchange Rate in the 1980s 309 Appendix 15.A: Description of Data 312 References 313 Index 331