Overreaction and Diagnostic Expectations in Macroeconomics

Pedro Bordalo, Nicola Gennaioli and Andrei Shleifer

No 30356, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present the case for the centrality of overreaction in expectations for addressing important challenges in finance and macroeconomics. First, non-rational expectations by market participants can be measured and modeled in ways that address some of the key challenges posed by the rational expectations revolution, most importantly the idea that economic agents are forward-looking. Second, belief overreaction can account for many long-standing empirical puzzles in macro and finance, which emphasize the extreme volatility and boom-bust dynamics of key time series, such as stock prices, credit, and investment. Third, overreaction relies on psychology and is disciplined by survey data on expectations. This suggests that relaxing the assumption of rational expectations is a promising strategy, helps theory and evidence go together, and offers a unified view of a great deal of data.

JEL-codes: D9 E03 E44 G02 (search for similar items in EconPapers)
Date: 2022-08
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Published as Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2022. "Overreaction and Diagnostic Expectations in Macroeconomics," Journal of Economic Perspectives, American Economic Association, vol. 36(3), pages 223-244, Summer.
Published as Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2022. "Overreaction and Diagnostic Expectations in Macroeconomics," Journal of Economic Perspectives, vol 36(3), pages 223-244.

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