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Diagnostic Expectations and Credit Cycles

Author

Listed:
  • PEDRO BORDALO
  • NICOLA GENNAIOLI
  • ANDREI SHLEIFER

Abstract

We present a model of credit cycles arising from diagnostic expectations—a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

Suggested Citation

  • Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2018. "Diagnostic Expectations and Credit Cycles," Journal of Finance, American Finance Association, vol. 73(1), pages 199-227, February.
    • Handle: RePEc:bla:jfinan:v:73:y:2018:i:1:p:199-227
    DOI: 10.1111/jofi.12586
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    JEL classification:

    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G01 - Financial Economics - - General - - - Financial Crises
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles

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