Fear of model misspecification and the robustness premium
AbstractRobust decision making implies welfare costs or robustness premia when the approximating model is the true data generating process. To examine the importance of these premia at the aggregate level we employ a simple two-sector dynamic general equilibrium model with human capital and introduce an additional form of precautionary be- havior. The latter arises from the robust decision maker's ability to reduce the effects of model misspecification through allocating time and existing human capital to this end. We find that the extent of the robustness premia critically depends on the productivity of time rela- tive to that of human capital. When the relative efficiency of time is low, despite transitory welfare costs, there are gains from following ro- bust policies in the long-run. In contrast, high relative productivity of time implies misallocation costs that remain even in the long-run. Fi- nally, depending on the technology used to reduce model uncertainty, we find that while increasing the fear of model misspecification leads to a net increase in precautionary behavior, investment and output can fall.
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Bibliographic InfoPaper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2010_24.
Date of creation: Sep 2010
Date of revision:
Other versions of this item:
- Konstantinos Angelopoulos & Jim Malley, 2010. "Fear of Model Misspecification and the Robustness Premium," CESifo Working Paper Series 3186, CESifo Group Munich.
- Angelopoulos, Konstantinos & Malley, James, 2010. "Fear of model misspecifcation and the robustness premium," SIRE Discussion Papers 2010-79, Scottish Institute for Research in Economics (SIRE).
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