Keywords: Rational expectations, expected utility maximization, certainty equivalence, Jensen's inequality, natural rate, long run Phillips Curve
Abstract: The certainty equivalence principle states that only the mean
of a random variable is relevant to a decision maker facing
uncertainty. This principle considerably simplifies the application of
the idea of rational expectations considerably. Yet, certainty
equivalence does not in general apply outside of the special
case of the quadratic objective function subject to linear
constraints. I use the standard augmented Phillips Curve
to demonstrate the significant effects that occur with the
breakdown of certainty equivalence.
Full paper (333 KB PDF)
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Last update: August 25, 1998