The Importance of Diagnostic Expectations in Open Economies

Selim Elekdag, Mananirina Razafitsiory and Luis-Felipe Zanna

No 2025/246, IMF Working Papers from International Monetary Fund

Abstract: We develop and estimate a parsimonious New-Keynesian small open-economy model that incorporates Diagnostic Expectations (DE)—a behavioral alternative to Rational Expectations (RE). Under DE, agents systematically overreact to new information, generating additional endogenous volatility. Our empirical analysis provides robust support for the DE framework: it fits Canadian data significantly better than the nested RE benchmark and improves forecasts of key macroeconomic variables, including real GDP growth, even during crises such as the Global Financial Crisis. These gains arise because DE reshapes the transmission of shocks, amplifying their effects and strengthening the exchange-rate channel of monetary policy. As a result, the relative importance of structural shocks shifts—with greater roles for supply shocks—and policymakers face a meaningfully worse inflation–output volatility trade-off. Taken together, our results highlight the relevance of behavioral expectations for open-economy dynamics and policy design.

Keywords: Small Open Economy; Diagnostic Expectations; Bayesian Estimation; Forecasting; policy design; IMF working papers; open-economy dynamics; inflation-output volatility trade-off; importance of Diagnostic Expectations; open-economy model; Inflation; Exchange rates; Consumption; Consumer price indexes; Nominal effective exchange rate; Global (search for similar items in EconPapers)
Pages: 52
Date: 2025-11-21
New Economics Papers: this item is included in nep-cba and nep-opm
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