Knightian uncertainty and stock-price movements: Why the REH present-value model failed empirically

Roman Frydman, Michael D. Goldberg, Nicholas Mangee

    Research output: Contribution to journalArticle

    Abstract

    Macroeconomic models that are based on either the rational expectations hypothesis (REH) or behavioral considerations share a core premise: All future market outcomes can be characterized ex ante with a single overarching probability distribution. This paper assesses the empirical relevance of this premise using a novel data set. The authors find that Knightian uncertainty, which cannot be reduced to a probability distribution, underpins outcomes in the stock market. This finding reveals the full implications of Robert Shiller’s ground-breaking rejection of the class of REH present-value models that rely on the consumption-based specification of the risk premium. The relevance of Knightian uncertainty is inconsistent with all REH models, regardless of how they specify the market’s risk premium. The authors’ evidence is also inconsistent with bubble accounts of REH models’ empirical difficulties. They consider a present-value model based on a New Rational Expectations Hypothesis, which recognizes the relevance of Knightian uncertainty in driving outcomes in real-world markets. Their novel data is supportive of the model’s implications that rational forecasting relies on both fundamental and psychological factors.

    Original languageEnglish (US)
    JournalEconomics
    Volume9
    DOIs
    StatePublished - Aug 18 2015

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    Keywords

    • Fundamentals
    • Knightian uncertainty
    • Presentvalue model
    • Psychology
    • Stock prices
    • Structural change

    ASJC Scopus subject areas

    • Economics, Econometrics and Finance(all)

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