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Anticipated Utility and Rational Expectations as Approximations of Bayesian Decision Making

  • Tim W. Cogley
  • Thomas J. Sargent

    (Department of Economics, University of California Davis)

For a Markov decision problem in which unknown transition probabilities serve as hidden state variables, we study the quality of two approximations to the decision rule of a Bayesian who each period updates his subjective distribu- tion over the transition probabilities by Bayes’ law. The first is the usual ratio- nal expectations approximation that assumes that the decision maker knows the transition probabilities. The second approximation is a version of Kreps’ (1998) 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 probabili- ties. For a range of consumption smoothing examples, the anticipated utility approximation outperforms the rational expectations approximation. The an- ticipated utility and Bayesian models augment market prices of risk relative to the rational expectations approximation.

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Paper provided by University of California, Davis, Department of Economics in its series Working Papers with number 523.

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Length: 46
Date of creation: 01 Mar 2005
Date of revision:
Handle: RePEc:cda:wpaper:05-23
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  1. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  2. Mark W. Watson, 1991. "Measures of Fit for Calibrated Models," NBER Technical Working Papers 0102, National Bureau of Economic Research, Inc.
  3. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1998. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True?," NBER Working Papers 6354, National Bureau of Economic Research, Inc.
  4. Andrew B. Abel, 2001. "An exploration of the effects of pessimism and doubt on asset returns," Working Papers 01-1, Federal Reserve Bank of Philadelphia.
  5. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  6. 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.
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