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The Virtues and Vices of Equilibrium and the Future of Financial Economics

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Abstract

The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn’t be a question of dogma, but should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics.

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File URL: http://cowles.econ.yale.edu/P/cd/d16a/d1647.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1647.

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Length: 68 pages
Date of creation: Mar 2008
Date of revision:
Publication status: Published in Complexity (Jan/Feb 2009), 14(3): 11-38
Handle: RePEc:cwl:cwldpp:1647

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Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
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Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Keywords: Equilibrium; Rational expectations; Efficiency; Arbitrage; Bounded rationality; Power laws; Disequilibrium; Zero intelligence; Market ecology; Agent based modeling;

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Cited by:
  1. Samuel E. Vazquez, 2009. "Scale Invariance, Bounded Rationality and Non-Equilibrium Economics," Papers 0902.3840, arXiv.org.
  2. Lee Smolin, 2009. "Time and symmetry in models of economic markets," Papers 0902.4274, arXiv.org.
  3. repec:hal:cesptp:halshs-00609824 is not listed on IDEAS
  4. LeBaron, Blake, 2012. "Heterogeneous gain learning and the dynamics of asset prices," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 424-445.
  5. Jean-Philippe Bouchaud, 2011. "Panel Statement: The endogenous dynamics of markets: price impact and feedback loops," Chapters, European Central Bank.
  6. Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2008. "More hedging instruments may destabilize markets (Revised version, April 2008)," CeNDEF Working Papers 08-04, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  7. Lotz, Aileen & Gosselin, Pierre, 2012. "A dynamic model of interactions between conscious and unconscious," MPRA Paper 36697, University Library of Munich, Germany.
  8. Hawkins, Raymond J. & Aoki, Masanao & Roy Frieden, B., 2010. "Asymmetric information and macroeconomic dynamics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(17), pages 3565-3571.
  9. repec:hal:journl:halshs-00609824 is not listed on IDEAS

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