Certainty equivalence and model uncertainty
Abstract: Simon?s and Theil?s certainty equivalence property justifies a convenient algorithm for solving dynamic programming problems with quadratic objectives and linear transition laws: first, optimize under perfect foresight, then substitute optimal forecasts for unknown future values. A similar decomposition into separate optimization and forecasting steps prevails when a decision maker wants a decision rule that is robust to model misspecification. Concerns about model misspecification leave the first step of the algorithm intact and affect only the second step of forecasting the future. The decision maker attains robustness by making forecasts with a distorted model that twists probabilities relative to his approximating model. The appropriate twisting emerges from a two-player zero-sum dynamic game.
Status: Published in Models and monetary policy conference (2004: March 26-27, Washington DC)
File(s): File format is application/pdf http://www.federalreserve.gov/events/conferences/mmp2004/pdf/hansensargent.pdf
Part of Series: Proceedings
Publication Date: 2005