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 Muthi?½s pathbreaking hypothesis, KUH represents participantsi?½ forecasts to be consistent with both uncertainties. KUH thus enables models of aggregate outcomes that 1) are premised on market participantsi?½ 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 modeli?½s quantitative predictions can be confronted with time-series data.