Model specification risk and uncertainty

Devajyoti Ghose and George Soulellis

Model uncertainty is fear of model misspecification.

Lars Hansen and Thomas Sargent

5.1 INTRODUCTION

In this chapter we address risk and uncertainty arising from model misspecification: what it is; what its consequences are; how it generates risk and uncertainty in the model life cycle; and how it may be mitigated.

In the quote above, Hansen and Sargent were concerned with the behaviour of economic agents who form expectations based on the best model that is available to them at the time: the “rational” part of rational expectations. Whether or not we believe in the strict version of rational expectations espoused in the 1980s (and plenty of reasons to be sceptical have emerged since), the uncertainty associated with models must lie at the centre of decisions made by financial institutions as economic agents.¹¹ In an extreme form of the theory, rational economic agents are able to forecast the effects of government policy (Hansen and Sargent were thinking of fiscal and monetary policy) with the same model as the Federal Reserve or the Bank of England (if that is the best available model) and incorporate these forecasts, such as a forecast of future inflation as a consequence of