We believe that economic theory, and its core, mathematical modeling of economic interaction, needs to fullfill the promise to provide helpful tools to explain currently observable phenomena, and to give useful guidance in policy making in the modern capitalist market system. It is questionable if this promise is currently fullfilled. In the recent years, economic theory was subject to criticism, for instance, during the financial crisis of 2008.

Economic theory matters. It provides the tools that will later be used by policy makers, and that will be taught in business schools. Here at the Max Planck Institute for Mathematics in the Sciences we develop new economic theory, with which we try to fullfill the mentioned promise.

We want to build our new theory on the following premises, which are deviations from main-stream academic economic thinking:

1. Prices Reflect Expectations, which are the Outcome of a Mutual Anticipation of Economic Agents
In our view, a key shortcoming of the currently established modeling paradigms to study macroeconomic development, that is, Dynamic Stochastic General Equilibrium and Rational Expectations models, is that here price movements are assumed to be caused by events exogenous to the economy, but not endogenously caused by changes in the higher order beliefs of the interacting agents. Higher order beliefs are beliefs of economic agents about the beliefs of other economic agents. For instance, banks may entertain beliefs about the beliefs of governments regarding the economic development. These higher order beliefs matter, as the bank may base its expectations and respective actions on these beliefs.

We argue that prices also contain information about the higher order beliefs of the agents. This then in turn implies that agents cannot fully distinguish if price movements are caused by a change in information about fundamentals, or a change in expectations of the other agents. We use this premise as a starting point for working on models to understand the link between the macroeconomy, financial markets, and policy making.

2. Markets May or May Not be Informationally Efficient
If economies are complex, and agents mutually anticipate each other, markets need no longer work informationally efficiently. This follows already from the fact that agents cannot distinguish if price changes are caused by changes in fundamental values or changes in higher order beliefs of other economic agents. In turn, we need to develop a new mathematical notion of information in economies. A useful notion of information should help us to understand the risks that are created by the aggregate economic process, for instance the aggregate risk of credit defaults.

Here in Leipzig, we work on such models. These models promise to help us to investigate which institutions make markets more informationally efficient.

References

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5. Ehrig, T. Jost, J. 2010a. Strategic Rational Expectations - Towards A Theory Of The Coordination of Expectations. Conference Paper. Spring 2010 Midwest Economic Theory Meeting, Northwestern University: Chicago.
6. Ehrig, T. Jost, J. 2010b. A Game Theoretical Approach to Expectation Formation in Markets. Conference Paper. XXXV Simposio de la Asociación Española de Economía (SAEe) , Madrid.
7. Ehrig, T. Jost, J. 2011. Reflexive Expectation Formation. Conference Paper. International Economic Association. 16th World Congress, Beijing. (PDF)
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10. Morris, S., Shin, H. 2006. Global Games: Theory and Applications. Chapter 3 (pp.57-114) in: Cambridge Collections Online, Cambr.Univ.Press. (Publisher, PDF)