Imperfect Knowledge

The financial sector can support growth but it can also cause crisis. The present crisis has exposedgaps in economists’ understanding of this dual potential.

Innovation. The word is evocative of ideas, products and processes which have somehow made the world a better place. Prior to the global financial crisis, many viewed financial innovation as unequivocally falling into this category.

In this paper, we examine one of the core puzzles in International Macroeconomics, the so-called “forward-discount anomaly.”

A core premise of contemporary economic models is that researchers can adequately specify in probabilistic terms how individuals alter the way they make decisions and how the processes underpinning market outcomes unfold over time.

A core puzzle in Önancial economics is the inability of standard risk-premium models to account for excess returns in currency and other asset markets.

This chapter surveys experimental research on networks in economics.

We call attention to the class of models that serve as the foundation for the rational expectations hypothesis (REH). Models in this class rule out completely any structural change that cannot be fully anticipated with a probabilistic or other quantitative rule. REH models are abstractions of rational decision-making, but only in a hypothetical world in which participants can fully anticipate when and how they might revise their understanding of the process driving outcomes.

Behavioral finance views stock-market investors’ expectations as largely unrelated to fundamental factors. Relying on survey data, this paper presents econometric evidence that fundamentals are a major driver of investors’ expectations.

Taking a long‐run view from economic history, I make three points about instability in financial markets. First, I argue that economic historians have a relatively good understanding of the proximate causes of financial crises.

In the seemingly never-ending aftermath to the economic crisis that began in 2007, there is little disagreement that financial markets are characterized by instability rather than stability.

In modern economies, individuals and companies engage in innovative activities, discovering new ways to use existing physical and human capital, and new technologies in which to invest. The institutional and broader social context within which these activities take place also changes in novel ways.

These are extraordinary times for central banks. Near zero interest rates and massive liquidity injections are still failing to bring life back to so many economies in the developed world.

The exteriors of major central banks may be solid marble and doric columns, but, inside, monetary policy remains a work in progress.

There is much anecdotal evidence in the popular media, backed up by survey research, that participants in currency markets pay close attention to fundamental economic variables in forming their forecasts of future exchange rates.

For macroeconomists, an individual is rational if she uses her understanding of the way the economy works in making decisions that do not conflict with her objectives.