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Incorporating Diagnostic Expectations into the New Keynesian Framework

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Abstract

Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach to expectation formation can be productively integrated into the New Keynesian framework. 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. We perform Bayesian estimation of a rich medium-scale model that incorporates consensus forecast data. Our estimate of the diagnosticity parameter is in line with previous studies. Moreover, we find empirical evidence in favor of the diagnostic model. Diagnostic expectations offer new propagation mechanisms to explain fluctuations.

Suggested Citation

  • Jean-Paul L’Huillier & Sanjay R. Singh & Donghoon Yoo, 2023. "Incorporating Diagnostic Expectations into the New Keynesian Framework," IEAS Working Paper : academic research 23-A004, Institute of Economics, Academia Sinica, Taipei, Taiwan.
    • Handle: RePEc:sin:wpaper:23-a004
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    Cited by:

    1. Na, Seunghoon & Yoo, Donghoon, 2025. "Overreaction and macroeconomic fluctuation of the external balance," Journal of Monetary Economics, Elsevier, vol. 151(C).
    2. Gerotto, Luca & Paradiso, Antonio & Pellizzari, Paolo, 2025. "A tale of inattentiveness and the loss function: A model for household-level macroeconomic expectations," Journal of Economic Behavior & Organization, Elsevier, vol. 236(C).
    3. Fontanier, Paul, 2025. "Optimal policy for behavioral financial crises," Journal of Financial Economics, Elsevier, vol. 166(C).
    4. Antoine Camous & Alejandro Van der Ghote, 2023. "Evaluating the Financial Instability Hypothesis: A Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations," CRC TR 224 Discussion Paper Series crctr224_2023_431v2, University of Bonn and University of Mannheim, Germany, revised May 2024.
    5. Tom D. Holden, 2024. "Robust Real Rate Rules," Econometrica, Econometric Society, vol. 92(5), pages 1521-1551, September.
    6. Anastasiia Antonova & Mykhailo Matvieiev & Céline Poilly, 2024. "Supply Shocks in the Fog: The Role of Endogenous Uncertainty," AMSE Working Papers 2427, Aix-Marseille School of Economics, France.
    7. Jonathan J Adams, 2024. "Optimal Policy Without Rational Expectations: A Sufficient Statistic Solution," Working Papers 001011, University of Florida, Department of Economics.
    8. Jinting Guo, 2025. "On the Identification of Diagnostic Expectations: Econometric Insights from DSGE Models," Papers 2509.08472, arXiv.org, revised Sep 2025.
    9. Jean-Paul L’Huillier & Pierlauro Lopez & Sanjay R. Singh, 2025. "A Behavioral Foundation for the Investment Wedge," Working Paper Series 2025-22, Federal Reserve Bank of San Francisco.
    10. Andres Blanco & Pablo Ottonello & Tereza Ranošová, 2024. "The Dynamics of Large Inflation Surges," FRB Atlanta Working Paper 2024-9, Federal Reserve Bank of Atlanta.
    11. Antoine Camous & Alejandro Van der Ghote, 2025. "Evaluating the Financial Instability Hypothesis: a Positive and Normative Analysis of Leveraged Risk-Taking and Extrapolative Expectations," Working papers 1009, Banque de France.
    12. George-Marios Angeletos, 2023. "Comment on "Long Term Expectations and Aggregate Fluctuations" 2," NBER Chapters, in: NBER Macroeconomics Annual 2023, volume 38, pages 348-362, National Bureau of Economic Research, Inc.
    13. James Cloyne & Òscar Jordà & Sanjay R. Singh & Alan M. Taylor, 2025. "Asset Prices and Credit with Diagnostic Expectations," Working Paper Series 2025-15, Federal Reserve Bank of San Francisco.

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    Keywords

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    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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