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Gresham's Law of Model Averaging

In-Koo Cho and Kenneth Kasa ()

American Economic Review, 2017, vol. 107, issue 11, 3589-3616

Abstract: A decision maker doubts the stationarity of his environment. In response, he uses two models, one with time-varying parameters, and another with constant parameters. Forecasts are then based on a Bayesian model averaging strategy, which mixes forecasts from the two models. In reality, structural parameters are constant, but the (unknown) true model features expectational feedback, which the reduced-form models neglect. This feedback permits fears of parameter instability to become self-confirming. Within the context of a standard asset-pricing model, we use the tools of large deviations theory to show that even though the constant parameter model would converge to the rational expectations equilibrium if considered in isolation, the mere presence of an unstable alternative drives it out of consideration.

JEL-codes: C63 D83 D84 (search for similar items in EconPapers)
Date: 2017
Note: DOI: 10.1257/aer.20160665
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Working Paper: GRESHAM’S LAW OF MODEL AVERAGING (2016) Downloads
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Handle: RePEc:aea:aecrev:v:107:y:2017:i:11:p:3589-3616