Robust Permanent Income and Pricing with Filtering

Abstract

A planner and agent in a permanent-income economy cannot observe part of the state, regard their model as an approximation, and value decision rules that are robust across a set of models. They use robust decision theory to choose allocations. Equilibrium prices reflect the preference for robustness and so embody a "market price of Knightian uncertainty." We compute market prices of risk and compare them with a model that assumes that the state is fully observed. We use detection error probabilities to constrain a single parameter that governs the taste for robustness.

Keywords: Kalman filter, approximating model, Knightian uncertainty, robustness, equity premium, market price of uncertainty, permanent income

JEL Classification: D11, D91, E21