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Incorporating Diagnostic Expectations into the New Keynesian Framework

Author

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  • Jean-Paul L'Huillier
  • Sanjay R. Singh
  • Donghoon Yoo

    (Department of Economics, University of California Davis)

Abstract

Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach for expectation formation can be productively integrated into the New Keynesian framework. To this end, we start by offering a first technical treatment of diagnostic expectations in linear macroeconomic models. Diagnostic expectations generate endogenous extrapolation in general equilibrium. We show that diagnostic expectations generate extra amplification in the presence of nominal frictions; a fall in aggregate supply generates a Keynesian recession; fiscal policy is more effective at stimulating the economy; with imperfect information, diagnostic expectations generate delayed overreaction of aggregate variables. Bayesian estimation of a rich medium-scale model delivers estimates of the diagnosticity parameter that is in line with previous studies. Moreover, we find strong empirical evidence in favor of the diagnostic model.

Suggested Citation

  • Jean-Paul L'Huillier & Sanjay R. Singh & Donghoon Yoo, 2021. "Incorporating Diagnostic Expectations into the New Keynesian Framework," Working Papers 339, University of California, Davis, Department of Economics.
  • Handle: RePEc:cda:wpaper:339
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    2. Holden, Tom D., 2022. "Robust real rate rules," Discussion Papers 42/2022, Deutsche Bundesbank.
    3. Jonathan J Adams, 2024. "Optimal Policy Without Rational Expectations: A Sufficient Statistic Solution," Working Papers 001011, University of Florida, Department of Economics.
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    More about this item

    Keywords

    diagnostic expectations; macroeconomics; volatility; linear rational expectations; overshooting;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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