The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth’s Consistency Constraint in Modeling Aggregate Outcomes

Abstract

This paper proposes the Knightian Uncertainty Hypothesis (KUH), a new approach to macroeconomics and finance theory. KUH rests on a novel mathematical framework that characterizes both measurable and Knightian uncertainty about economic outcomes. Relying on this framework and Muth’s pathbreaking hypothesis, KUH represents participants’ forecasts to be consistent with both uncertainties. KUH thus enables models of aggregate outcomes that 1) are premised on market participants’ rationality, and 2) accord a role to both fundamental and psychological (and other non-fundamental) factors in driving outcomes. The paper also suggests how a KUH model’s quantitative predictions can be confronted with time-series data.

Keywords: Unforeseeable Change; Knightian Uncertainty; Muth’s Hypothesis; Model Ambiguity; REH; Behavioral Finance

JEL Classification: C02; C51; E00; D84; E00; G41