Overreaction and Diagnostic Expectations in Macroeconomics

Pedro Bordalo, Nicola Gennaioli and Andrei Shleifer

Journal of Economic Perspectives, 2022, vol. 36, issue 3, 223-44

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 promises a unified view of a great deal of data.

JEL-codes: D83 D84 E13 E32 E44 G14 G31 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (21)

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Working Paper: Overreaction and Diagnostic Expectations in Macroeconomics (2022)
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DOI: 10.1257/jep.36.3.223

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