Rational expectations and ambiguity: A comment on Abel (2002)

Abel (2002) proposes a resolution of the riskfree rate and the equity premium puzzles by considering pessimism and doubt. Pessimism is characterized by subjective probabilistic beliefs about consumption growth rates that are stochastically dominated by the objective distribution. The subjective distribution is characterized by doubt if it is a mean−preserving spread of the objective distribution. This note offers a decision theoretic foundation of Abel's ad−hoc definitions of pessimism and doubt under the assumption that individuals exhibit ambiguity attitudes in the sense of Schmeidler (1989). In particular, we show that the behavior of a representative agent, who resolves her uncertainty with respect to the true distribution of asset returns in a pessimistic way, is the equivalent to pessimism in Abel's sense. Furthermore, a representative agent, who takes into account pessimistic as well as optimistic considerations, may result in the equivalent to doubt in Abel's sense. We thank Jürgen Eichberger, Itzhak Gilboa, David Schmeidler and an anonymous referee for helpful comments and suggestions. Financial support from the Deutsche Forschungsgemeinschaft, Sonderforschungsbereich 504, is gratefully acknowledged. Citation: Ludwig, Alexander and Alexander Zimper, (2006) "Rational expectations and ambiguity: A comment on Abel (2002)." Economics Bulletin, Vol. 4, No. 2 pp. 1−15 Submitted: September 28, 2005. Accepted: January 11, 2006. URL: http://www.economicsbulletin.com/2006/volume4/EB−05D80045A.pdf