Ambiguity and Economic Activity: Implications for the Current Crisis in Credit Markets

This chapter discusses some recent developments in economics regarding theories of decision making in conditions of uncertainty and argues that these new theories and models are singularly useful in explaining and understanding the ongoing credit crises. Moreover, it argues that the understanding based on these theories has significant policy implications about how the crises may be alleviated. While the formal articulation of these theories took place only recently, the ideas that formed their core had been discussed by Keynes1 and Knight2 in the 1920s. They had pointed out that for many important economic decisions, the decision maker (DM) faces “genuine” uncertainty such that he does not have reliable information about the relevant odds and that in such circumstances the uncertainty perceived by the DM may not be summarized by a single probability distribution, as in standard practice. It was also posited that a DM’s choice behavior would also be determined by his taking into account how much he knew about the relevant odds. In decision making under conditions of uncertainty it is often the case that the decision maker’s knowledge about the likelihood of contingent events is consistent with more than one probability distribution.