Model uncertainty: the Economist and the Evil agent
Méphistophélès in Faust’s study Eugène Delacroix Introducing “Doubts and Variability” by Rhys Bidder (Federal Reserve Bank of San Francisco) and Matthew E. Smith (Federal Reserve Board). Working Paper (First Draft Sept 4, 2010 – current version Aug 4, 2011). One of the most enduring puzzles in the macrofinance literature is the equity premium puzzle. A manifestation of this puzzle is the difficulty of designing a model that simultaneously generates a substantial market price of risk and a low risk free rate, while also respecting stylized facts regarding consumption dynamics, as discussed by Hansen and Singleton (1982) and Mehra and Prescott (1985). In this paper Bidder and Smith show that the interaction of stochastic volatility in consumption with a fear of model misspecification can bring new pieces to the puzzle. The agent in their heteroskedastic (with time-varying variance) endowment economy does not fully trust the joint conditional distribution of the...