Certainty equivalence and model uncertainty

Lars Peter Hansen and Thomas Sargent ()

Proceedings, 2005, pages 17-38

Abstract: Simon’s and Theil’s certainty equivalence property justifies a convenient algorithm for solving dynamic programming problems with quadratic objectives and linear transition laws: first, optimize under perfect foresight, then substitute optimal forecasts for unknown future values. A similar decomposition into separate optimization and forecasting steps prevails when a decision maker wants a decision rule that is robust to model misspecification. Concerns about model misspecification leave the first step of the algorithm intact and affect only the second step of forecasting the future. The decision maker attains robustness by making forecasts with a distorted model that twists probabilities relative to his approximating model. The appropriate twisting emerges from a two-player zero-sum dynamic game.

Date: 2005
View list of references View citations in EconPapers

Downloads: (external link)
http://www.federalreserve.gov/events/conferences/mmp2004/pdf/hansensargent.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Ordering information: This journal article can be ordered from

Access Statistics for this article

More articles in Proceedings from Board of Governors of the Federal Reserve System (U.S.)
Contact information at EDIRC.
Series data maintained by Diane Rosenberger ().