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Anticipated Utility and Rational Expectations as Approximations of Bayesian Decision Making

Author

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  • Tim W. Cogley
  • Thomas J. Sargent

    (Department of Economics, University of California Davis)

Abstract

For a Markov decision problem in which unknown transition probabilitiesserve as hidden state variables, we study the quality of two approximations tothe 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 thetransition probabilities. The second approximation is a version of Kreps? (1998)anticipated utility model in which decision makers update using Bayes? law butoptimize in a way that is myopic with respect to their updating of probabili-ties. For a range of consumption smoothing examples, the anticipated utilityapproximation outperforms the rational expectations approximation. The an-ticipated utility and Bayesian models augment market prices of risk relative tothe rational expectations approximation.

Suggested Citation

  • Tim W. Cogley & Thomas J. Sargent, 2005. "Anticipated Utility and Rational Expectations as Approximations of Bayesian Decision Making," Working Papers 68, University of California, Davis, Department of Economics.
  • Handle: RePEc:cda:wpaper:68
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    References listed on IDEAS

    as
    1. Abel, Andrew B., 2002. "An exploration of the effects of pessimism and doubt on asset returns," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1075-1092, July.
    2. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711.
    3. 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.
    4. Pok-sang Lam & Stephen G. Cecchetti & Nelson C. Mark, 2000. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?," American Economic Review, American Economic Association, vol. 90(4), pages 787-805, September.
    5. Sargent, Thomas J., 1993. "Bounded Rationality in Macroeconomics: The Arne Ryde Memorial Lectures," OUP Catalogue, Oxford University Press, number 9780198288695.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Rational expectations; Bayes? Law; anticipated utility; market price ofrisk;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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