Change and expectations in macroeconomic models: recognizing the limits to knowability

Abstract

This paper argues that contemporary macroeconomic and finance models suffer from insuperable epistemological flaws and that their empirical difficulties – which are particularly apparent in modeling market participants' expectations – can be traced to economists' core premise that they can adequately specify in probabilistic terms how individuals alter the way they make decisions and how the processes underpinning market outcomes unfold over time. We refer to such accounts of change as determinate. The first part examines how this core premise has derailed the development of macroeconomic analysis for the last four decades. The second part sketches how imperfect knowledge economics (IKE) jettisons conventional models' core premise and how doing so helps to overcome these models' epistemological flaws. By opening economic models to change, that is, at least in part, indeterminate, and by recognizing imperfect knowledge on the part of economists, IKE explores the frontier of what empirically relevant mathematical macroeconomic and finance models can deliver.