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Rethinking the Role of the Representativeness Heuristic in Macroeconomics and Finance Theory

Author

Listed:
  • Roman Frydman

    (Department of Economics, New York University)

  • Morten Nyboe Tabor

    (Institute for New Economic Thinking (INET))

Abstract

We propose a novel interpretation and formalization of Kahneman and Tversky's findings in the Linda experiment which implies that subjects are rational in the sense of Muth's hypothesis and provides an approach to specifying rational assessment of uncertainty in macroeconomic models. Behavioral-finance theorists have appealed to Kahneman and Tversky's findings as an empirical foundation for a general approach replacing rational expectations. We show that behavioral models' specifications of participants' irrational forecasts and predictable errors are incompatible with Kahneman and Tversky's findings. Our interpretation of Kahneman and Tversky's findings is supportive of Lucas's compelling critique of inconsistent macroeconomic models.

Suggested Citation

  • Roman Frydman & Morten Nyboe Tabor, 2020. "Rethinking the Role of the Representativeness Heuristic in Macroeconomics and Finance Theory," Working Papers Series inetwp142, Institute for New Economic Thinking.
    • Handle: RePEc:thk:wpaper:inetwp142
    DOI: 10.36687/inetwp142
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    File URL: https://doi.org/10.36687/inetwp142
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    Keywords

    Uncertainty in Economic Models; Kahneman and Tversky's Experimental Findings; Behavioral Finance; Muth's Hypothesis; REH.;
    All these keywords.

    JEL classification:

    • B41 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Economic Methodology
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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