Monetary and Economic Studies Vol.19, No. S-1 / February 2001

Acknowledging Misspecification in Macroeconomic Theory

Lars Peter Hansen, Thomas J. Sargent

We explore methods for confronting model misspecification in macroeconomics. We construct dynamic equilibria in which private agents and policy makers recognize that models are approximations. We explore two generalizations of rational expectations equilibria. In one of these equilibria, decision makers use dynamic evolution equations that are imperfect statistical approximations, and in the other misspecification is impossible to detect even from infinite samples of time-series data. In the first of these equilibria, decision rules are tailored to be robust to the allowable statistical discrepancies. Using frequency domain methods, we show that robust decision makers treat model misspecification like time-series econometricians.

Keywords: Robustness; Model misspecification; Monetary policy; Rational expectations

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2001 Bank of Japan All Rights Reserved.

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