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Imperfect Knowledge Economics:
Exchange Rates and Risk
Roman Frydman & Michael D. Goldberg
Foreword by Edmund S. Phelps

Book Description | Reviews
Chapter 1 [in PDF format] | Foreword by Edmund S. Phelps [HTML] or [PDF format]


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

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