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A Macro-Finance Model with Sentiment

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  • Peter Maxted

Abstract

This paper incorporates diagnostic expectations into a general equilibrium macroeconomic model with a financial intermediary sector. Diagnostic expectations are a forward-looking model of extrapolative expectations that overreact to recent news. Frictions in financial intermediation produce non-linear spikes in risk premia and slumps in investment during periods of financial distress. The interaction of sentiment with financial frictions generates a short-run amplification effect followed by a long-run reversal effect, termed the feedback from behavioural frictions to financial frictions. The model features sentiment-driven financial crises characterized by low pre-crisis risk premia and neglected risk. The conflicting short-run and long-run effect of sentiment produces boom–bust investment cycles. The model also identifies a stabilizing role for diagnostic expectations. Under the baseline calibration, financial crises are less likely to occur when expectations are diagnostic than when they are rational.

Suggested Citation

  • Peter Maxted, 2024. "A Macro-Finance Model with Sentiment," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 91(1), pages 438-475.
    • Handle: RePEc:oup:restud:v:91:y:2024:i:1:p:438-475.
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    File URL: http://hdl.handle.net/10.1093/restud/rdad023
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    Citations

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    Cited by:

    1. Andries, Marianne & Bianchi, Milo & Huynh, Karen & Pouget, Sébastien, 2024. "Return Predictability, Expectations, and Investment: Experimental Evidence," TSE Working Papers 1561, Toulouse School of Economics (TSE).
    2. John Duffy & Nobuyuki Hanaki & Donghoon Yoo, 2025. "Overreaction in Expectations under Signal Extraction: Experimental Evidence," ISER Discussion Paper 1293, Institute of Social and Economic Research, The University of Osaka.
    3. Slonimczyk, Fabian, 2025. "This Candidate is [MASK]. Prompt-based Sentiment Extraction and Reference Letters," MPRA Paper 126675, University Library of Munich, Germany.
    4. Ulrich Roschitsch & Hannes Twieling, 2025. "United in Booms, Divided in Busts: Regional House Price Cycles and Monetary Policy," Staff Working Papers 25-36, Bank of Canada.
    5. Fontanier, Paul, 2025. "Optimal policy for behavioral financial crises," Journal of Financial Economics, Elsevier, vol. 166(C).
    6. Dmitry Novikov, 2026. "Consumers' Inflation Expectations in Russia and the US: Testing the Diagnostic Expectations Hypothesis," Russian Journal of Money and Finance, Bank of Russia, vol. 85(1), pages 35-62, March.
    7. Bizzarri, Matteo & d’Arienzo, Daniele, 2024. "The social value of overreaction to information," Journal of Mathematical Economics, Elsevier, vol. 115(C).
    8. Benjamin Fan & Edward Qiao & Anran Jiao & Zhouzhou Gu & Wenhao Li & Lu Lu, 2025. "Deep Learning for Solving and Estimating Dynamic Macro-finance Models," Computational Economics, Springer;Society for Computational Economics, vol. 65(6), pages 3885-3921, June.
    9. Sharma, Vivek, 2026. "Lending relationships and boom–bust cycles," Journal of Financial Stability, Elsevier, vol. 83(C).
    10. Mikhail Stolbov & Maria Shchepeleva, 2026. "Measuring global financial stress: is there any role for large language models?," Annals of Finance, Springer, vol. 22(1), pages 1-22, June.
    11. Li, Rui & Li, Jianping & Zhu, Xiaoqian, 2025. "Downside belief disagreements and financial instability: Evidence from risk factor disclosures in U.S. financial institutions’ 10-K filings," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 99(C).

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