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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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