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Gresham’S Law Of Model Averaging

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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 linear present value asset pricing model, we use the tools of large deviations theory to show that even though the constant parameter model would converge to the (constant parameter) Rational Expectations Equilibrium if considered in isolation, the mere presence of an unstable alternative drives it out of consideration.

Suggested Citation

  • In-Koo Cho & Kenneth Kasa, 2016. "Gresham’S Law Of Model Averaging," Discussion Papers dp16-06, Department of Economics, Simon Fraser University.
    • Handle: RePEc:sfu:sfudps:dp16-06
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    References listed on IDEAS

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    Cited by:

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    3. Guo, Bin & Huang, Fuzhe & Li, Kai, 2022. "Time to build and bond risk premia," Journal of Economic Dynamics and Control, Elsevier, vol. 136(C).
    4. Audzei, Volha & Slobodyan, Sergey, 2022. "Sparse restricted perceptions equilibrium," Journal of Economic Dynamics and Control, Elsevier, vol. 139(C).
    5. Yuan, Lingran & Zhang, Qizheng & Wang, Shuo & Hu, Weibin & Gong, Binlei, 2022. "Effects of international trade on world agricultural production and productivity: evidence from a panel of 126 countries 1962-2014," International Food and Agribusiness Management Review, International Food and Agribusiness Management Association, vol. 25(2), March.
    6. Lingran Yuan & Shurui Zhang & Shuo Wang & Zesen Qian & Binlei Gong, 2021. "World agricultural convergence," Journal of Productivity Analysis, Springer, vol. 55(2), pages 135-153, April.

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    More about this item

    Keywords

    model averaging; asset pricing;

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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