Real Credit Cycles

Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer and Stephen Terry

No 28416, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We incorporate diagnostic expectations into a workhorse neoclassical business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnostic overreaction estimated from US firm forecasts generates economic fragility during good times, countercyclical credit spreads, and boom-bust credit cycles at the firm and aggregate levels. Good times predict future disappointment, spread increases, low bond returns, and investment declines. To generate the size of spread increases observed during 2008-9, the model requires only disappointment of overoptimistic beliefs rather than large negative shocks. Diagnostic expectations offer a realistic, parsimonious way to produce financial reversals in business cycle models.

JEL-codes: E03 E32 E44 (search for similar items in EconPapers)
Date: 2021-01
New Economics Papers: this item is included in nep-bec, nep-cwa, nep-fdg and nep-mac
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