Rational expectations and ambiguity: A comment on Abel
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2006
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Economics Bulletin
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Economics Bulletin
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University of Cape Town
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Abstract
Abel (2002) proposes a resolution of the riskfree rate and the equity premium puzzles by
considering pessimism and doubt. Pessimism is characterized by subjective probabilistic
beliefs about consumption growth rates that are stochastically dominated by the objective
distribution. The subjective distribution is characterized by doubt if it is a mean−preserving
spread of the objective distribution. This note offers a decision theoretic foundation of Abel's
ad−hoc definitions of pessimism and doubt under the assumption that individuals exhibit
ambiguity attitudes in the sense of Schmeidler (1989). In particular, we show that the
behavior of a representative agent, who resolves her uncertainty with respect to the true
distribution of asset returns in a pessimistic way, is the equivalent to pessimism in Abel's
sense. Furthermore, a representative agent, who takes into account pessimistic as well as
optimistic considerations, may result in the equivalent to doubt in Abel's sense.
Description
Reference:
Zimper, A. & Ludwig, A. (2006). Rational expectations and ambiguity: A comment on Abel (2002). Economics Bulletin, 4(2),1-15.