Quantitative Economics: Jul, 2010, Volume 1, Issue 1

Fragile beliefs and the price of uncertainty

Lars Peter Hansen, Thomas J Sargent

A representative consumer uses Bayes’ law to learn about parameters of several models and to construct probabilities with which to perform ongoing model averaging. The arrival of signals induces the consumer to alter his posterior distribution over models and parameters. The consumer’s specification doubts induce him to slant probabilities pessimistically. The pessimistic probabilities tilt toward a model that puts long-run risks into consumption growth. That contributes a countercyclical history-dependent component to prices of risk.

Keywords. Learning, Bayes’ law, robustness, risk sensitivity, pessimism, prices of risk.

JEL classification. C11, C44, C72, E44, G12.

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