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Thursday, January 16, 2014

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DR@W Forum: Harbir Lamba (Mathematics Department, George Mason University)

Harbir Lamba (Mathematics Department, George Mason University)

Behavioural economics, bounded rationality and disequilibrium in economic and financial systems

Models that admit only equilibrium solutions are prevalent in economics and finance. Such solutions evolve only in response to exogenous changes but, worryingly, their robustness to changes in the modeling assumptions and the possibility of non-equilibrium alternatives is rarely considered.

A simple agent-based model will be presented that can be used to introduce various forms of bounded rationality and the findings of behavioral economics into such equilibrium models. The model will be used to demonstrate that the equilibrium solutions of asset pricing in financial markets (variants of Brownian motion) break down completely in the presence of even very low levels of herding (either rational or irrational). The resulting far-from-equilibrium solutions are much closer to the observed statistics of financial markets with bubbles and crashes of all sizes arising quite naturally as an emergent phenomenon.

At a more abstract level, the averaging assumptions that are required for equilibrium solutions are being `stress-tested' by embedding those models within more general agent-based frameworks that are capable of endogenous, far-from-equilibrium, dynamics. If time permits I shall discuss how such stability testing can be applied to other equilibrium models such as the supply/demand curves of micro-economics and the DSGE models of macro-economics.

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