On the mathematical basis of inter-temporal optimization

Working paper

Almost no economic time series is either weakly or strictly stationary: distributions of economic variables shift over time. Thus, the present treatment of expectations in economic theories of inter-temporal optimization is inappropriate. It cannot be proved that conditional expectations based on the current distribution are minimum mean-square error 1-step ahead predictors when unanticipated breaks occur, and consequentially, the law of iterated expectations then fails inter-temporally. A second consequence is that dynamic stochastic general equilibrium models are intrinsically non-structural.

Authors: Hendry, D; Mizon, G

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2010-08-01
• Paper number: 497
• Keywords: unanticipated breaks; conditional expectations; law of iterated expectations; inter-temporal optimization