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Empirical Rationality in the Stock Market

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Rational expectations models make stringent assumptions on the agent'sknowledge about the true model. This paper introduces a model in which therational agent realizes that using a given model involves approximation errors,and adjusts behavior accordingly. If the researcher accounts for this empiricalrationality on part of the agent, the resulting empirical model assignslikelihood to the data actually observed, unlike in the unmodified rational expectationscase. A Lucas (1978)-type asset pricing model which incorporatesempirical rationality is constructed and estimated using U.S. stock data. Theequilibrium asset pricing function is seriously affected by the existence of approximationerrors and the descriptive properties and normative implicationsof the model are significantly improved. This suggests that investors do not| and should not | ignore approximation errors.Keywords: Approximation errors, model uncertainty, estimation of structuralmodels, rational expectations, asset pricing.

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Peter Raahauge

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