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Finance and Economics Discussion Series
The Finance and Economics Discussion Series logo links to FEDS home page Certainty Equivalence and the Non-Vertical Long Run Phillips Curve
Yvan Lengwiler

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.

Keywords: Rational expectations, expected utility maximization, certainty equivalence, Jensen's inequality, natural rate, long run Phillips Curve

Full paper (333 KB PDF)

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Last update: August 25, 1998