Imperfect Knowledge Economics

Posing a major challenge to economic orthodoxy,Imperfect Knowledge Economicsasserts that exact models of purposeful human behavior are beyond the reach of economic analysis. Roman Frydman and Michael Goldberg argue that the longstanding empirical failures of conventional economic models stem from their futile efforts to make exact predictions about the consequences of rational, self-interested behavior. Such predictions, based on mechanistic models of human behavior, disregard the importance of individual creativity and unforeseeable sociopolitical change. Scientific though these explanations may appear, they usually fail to predict how markets behave. And, the authors contend, recent behavioral models of the market are no less mechanistic than their conventional counterparts: they aim to generate exact predictions of "irrational" human behavior. Frydman and Goldberg offer a long-overdue response to the shortcomings of conventional economic models. Drawing attention to the inherent limits of economists' knowledge, they introduce a new approach to economic analysis: Imperfect Knowledge Economics (IKE). IKE rejects exact quantitative predictions of individual decisions and market outcomes in favor of mathematical models that generate only qualitative predictions of economic change. Using the foreign exchange market as a testing ground for IKE, this book sheds new light on exchange-rate and risk-premium movements, which have confounded conventional models for decades. Offering a fresh way to think about markets and representing a potential turning point in economics,Imperfect Knowledge Economicswill be essential reading for economists, policymakers, and professional investors.

Roman Frydman is professor of economics at New York University and the coauthor or coeditor of many books, including "Individual Forecasting and Aggregate Outcomes: "Rational Expectations" Examined". Michael D. Goldberg is associate professor of economics at the University of New Hampshire. His articles on international finance and macroeconomics have appeared in "Economic Journal" and "Journal of International Money and Finance".

Foreword by Edmund S. Phelps xiii
Acknowledgments xxi
List of Abbreviations xxiii
From Early Modern Economics to Imperfect Knowledge Economics1
Recognizing the Limits of Economists' Knowledge	p. 3
The Overreach of Contemporary Economics	p. 3
The Aim of This Book	p. 6
Contemporary Models in a World of Imperfect Knowledge	p. 8
The Non-Fully Intelligible Individual	p. 13
IKE Models	p. 14
IKE of Exchange Rates and Risk	p. 20
Imperfect Knowledge and Policy Analysis	p. 23
From Contemporary Economics to Imperfect Knowledge Economics	p. 24
A Tradition Interrupted	p. 26
The Stranglehold of the Contemporary Approach	p. 27
The Non-Fully Intelligible Individual in Early Modern Economics	p. 34
Jettisoning Insights from Early Modern Analysis	p. 38
Flawed Foundations: The Gross Irrationality of "Rational Expectations" and Behavioral Models	p. 41
Conventional and Behavioral Representations of Preferences with Uncertain Outcomes	p. 42
Self-Interest, Social Context, and Individual Decisions	p. 45
Individual Behavior and Aggregate Outcomes	p. 48
From Early Modern to Phelps's Microfoundations	p. 49
"Rational Expectations": Abandoning the Modern Research Program	p. 49
Diversity of Forecasting Strategies: The Gross Irrationality of "Rational Expectations"	p. 51
Inconsistency in Behavioral Models	p. 54
Reconsidering Modern Economics	p. 58
Sharp Predictions and Fully Predetermined Representations	p. 60
Qualitative Predictions of Change in Fully Predetermined Models	p. 65
IKE Models of Change 66 IKE Causal-Transition Paths	p. 70
Fully Prespecifying Change in the SocialContext	p. 71
Modeling Change in Outcomes with Fully Predetermined Probabilistic Rules	p. 72
Imperfect Knowledge Economics of Supply and Demand	p. 74
Fully Predetermined Representations of Supply and Demand	p. 76
Supply and Demand Analysis in Contemporary Models	p. 79
History as the Future and Vice Versa	p. 81
Supply and Demand Analysis in IKE Models	p. 82
Irreversibility of History in IKE Models	p. 86
"Anomalies" in Contemporary Models of Currency Markets	p. 89
The Overreach of Contemporary Models of Asset Markets	p. 91
Describing Forecasting Behavior	p. 92
Fully Predetermined Representations of Forecasting Strategies and Their Revisions	p. 93
Modeling Economic Change with a Time-Invariant Structure	p. 96
Models with Fully Predetermined Changes in Structure	p. 101
Prespecifying Collective Beliefs in Currency Markets: Bubble Models	p. 104
A Conventional Macroeconomic Model	p. 107
The "Puzzling" Behavior of Exchange Rates: Lost Fundamentals and Long Swings	p. 113
Exchange Rates and Macroeconomic Fundamentals: The Futile Search for a Fully Predetermined Relationship	p. 114
The Exchange Rate Disconnect Puzzle: An Artifact of the Contemporary Approach	p. 120
Macroeconomic Fundamentals over Long Horizons: Self-Limiting Long Swings	p. 121
Can REH Models Explain Long Swings in Exchange Rates?	p. 126
REH Bubble Models and the Pattern of Long Swings in Real World Markets	p. 131
Lost Fundamentals and Forsaken Rationality: Behavioral Models	p. 134
"Anomalous" Returns on Foreign Exchange: Is It Really Irrationality?	p. 138
The Record on Foreign Exchange Returns 140 An REH Risk Premium?	p. 144
Is Irrationality the Answer?	p. 147
The Forward-Discount "Anomaly": Another Artifact of the Contemporary Approach	p. 151
Imperfect Knowledge Economics of Exchange Rates and Risk	p. 153
Modeling Preferences in Asset Markets: Experimental Evidence and Imperfect Knowledge	p. 155
Prospect Theory and Speculative Decisions	p. 159
Endogenous Loss Aversion and Limits to Speculation	p. 167
Experimental Evidence and Behavioral Finance Models	p. 170
Moving beyond Behavioral Finance Models	p. 173
IKE Representations of Preferences in Asset Markets: Indi
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Imperfect Knowledge Economics

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