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Generalized Entropy and Model Uncertainty

Alexander Meyer-Gohde

No SFB649DP2017-017, SFB 649 Discussion Papers from Humboldt University, Collaborative Research Center 649

Abstract: I entertain a generalization of the standard Bolzmann-Gibbs-Shannon measure of entropy in multiplier preferences of model uncertainty. Using this measure, I derive a generalized exponential certainty equivalent, which nests the exponential certainty equivalent of the standard Hansen-Sargent model uncertainty formulation and the power certainty equivalent of the popular Epstein-Zin-Weil recursive preferences as special cases. Besides providing a model uncertainty rationale to these risk-sensitive preferences, the generalized exponential equivalent provides additional flexibility in modeling uncertainty through its introduction of pessimism into agents, causing them to overweight events made more likely in the worst case model when forming expectations. In a standard neoclassical growth model, I close the gap to the Hansen-Jagannathan bounds with plausible detection error probabilities using the generalized exponential equivalent and show that Hansen-Sargent and Epstein-Zin-Weil preferences yield comparable market prices of risk for given detection error probabilities.

Keywords: model uncertainty; robust control; recursive preferences; equity premium puzzle; Tsallis entropy (search for similar items in EconPapers)
JEL-codes: C61 C63 E17 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-upt
Date: 2017-08
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