Model Misspecification and Robustness in Economic Dynamics Concerns about model misspecification are pervasive in control theory and statistical theory. Control theorists and statisticians address these concerns by making control laws or decision rules robust.
Robust rules perform well under rich families of perturbations from an approximating model.
In his recent research, Lars Hansen builds on ideas from robust control theory to model individual economic decision-makers in decentralized dynamic economies. Investors use an approximating model of the dynamic evolution of an economy and adapt their decisions to potential forms of misspecified dynamics. By embracing model misspecification, investors are led to be more cautious in their decisions. Model uncertainty premia are encoded in the asset prices that clear security markets. These uncertainty premia, absent in standard models, can explain puzzlingly high market-based measures of risk aversion.