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Anticipated Utility And Rational Expectations As Approximations Of Bayesian Decision Making

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Author Info
Timothy Cogley
Thomas J. Sargent

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Abstract

We study a Markov decision problem with unknown transition probabilities. We compute the exact Bayesian decision rule and compare it with two approximations. The first is an infinite-history, rational-expectations approximation that assumes that the decision maker knows the transition probabilities. The second is a version of Kreps' anticipated-utility model in which decision makers update using Bayes' law but optimize in a way that is myopic with respect to their updating of probabilities. For several consumption-smoothing examples, the anticipated-utility approximation outperforms the rational expectations approximation. The rational expectations approximation misrepresents the market price of risk. Copyright 2008 by the Economics Department Of The University Of Pennsylvania And Osaka University Institute Of Social And Economic Research Association.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1468-2354.2008.00477.x
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Article provided by Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association in its journal International Economic Review.

Volume (Year): 49 (2008)
Issue (Month): 1 (02)
Pages: 185-221
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Handle: RePEc:ier:iecrev:v:49:y:2008:i:1:p:185-221

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  1. Cogley, Timothy & Morozov, Sergei & Sargent, Thomas J., 2005. "Bayesian fan charts for U.K. inflation: Forecasting and sources of uncertainty in an evolving monetary system," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1893-1925, November. [Downloadable!] (restricted)
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  1. Holden, Tom, 2008. "Rational macroeconomic learning in linear expectational models," MPRA Paper 10872, University Library of Munich, Germany. [Downloadable!]
  2. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics 0510022, EconWPA. [Downloadable!]
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  3. James B. Bullard & Jacek Suda, 2008. "The stability of macroeconomic systems with Bayesian learners," Working Papers 2008-043, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Timothy Cogley & Giorgio E. Primiceri & Thomas J. Sargent, 2008. "Inflation-Gap Persistence in the U.S," NBER Working Papers 13749, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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