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Indiana University Bloomington

BEPP

The Kelley Advantage

The department is home to the authors of Managerial Economics and Business Strategy and Games and Information: An Introduction to Game Theory, two of the nation’s leading textbooks in the field.

Research and Publications

Working Papers

Prominent Numbers, Indices and Ratios in Exchange Rate Determination and Financial Crashes: in Economists’ Models, in the Field and in the Laboratory

2009

Jürgen von Hagen, Robin Pope, Reinhard Selten, Sebastian Kube

Abstract

The prior paper in this sequel, Pope (2009) introduced the concept of a nominalist heuristic, defined as a focus on prominent numbers, indices or ratios. In this paper the concept is used to show three things in how scientists and practitioners analyse and evaluate to decide (conclude). First, in constructing theories such as purchasing power and interest parity to predict exchange rates and to advocate floating exchange rates, economists unwittingly employ nominalist heuristics. Second, nominalist heuristics have influenced actual exchange rates through the centuries, and this finding is replicated in the laboratory. Third, nominalist heuristics are incompatible with expected utility theory which excludes the evaluation stage, and are also incompatible with prospect theory which assumes that, while the evaluation stage can involve systematic mistakes, the overall decision situation is ultra simple. It is so simple that: a) economists and psychologists can mechanically model and identify what is a mistake, and b) decision makers can maximise. However, contrary to prospect theory, in the typical complex situation, neither a) nor b) holds. Assuming that a) and b) hold has resulted in the 1988 crisis from applying the Black Scholes formulae to forward exchange rates and contributed to sequel financial crises including that of 2007-2009. What is required is a fundamentally different class of models that allow for the progressive anticipated changes in knowledge ahead faced under risk and uncertainty, namely models under the umbrella of SKAT, the Stages of Knowledge Ahead Theory. The paper’s findings support a single world currency rather than variable unpredictable exchange rates subjected to the vagaries of how prominent numbers, ratios and indices influence events via the models of scientists and practitioners.

Citation

Robin Pope & Reinhard Selten & Sebastian Kube & Jürgen von Hagen, 2009. "Prominent Numbers, Indices and Ratios in Exchange Rate Determination and Financial Crashes: in Economists’ Models, in the Field and in the Laboratory," Bonn Econ Discussion Papers bgse18_2009, University of Bonn, Germany.

Keywords

nominalism, money illusion, heuristic, unpredictability, experiment, SKAT the Stages of Knowledge Ahead Theory, prominent numbers, prominent indices, prominent ratios, transparent policy, nominal equality, historical benchmarks, complexity, decision costs, evaluation, maximisation, Black Scholes, Lehmann Brothers, sub-prime crisis, central bank swaps.