Diagnostic Expectations and Credit Cycles

Pedro Bordalo, Nicola Gennaioli and Andrei Shleifer

No 22266, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

JEL-codes: E03 E17 E32 G01 G02 (search for similar items in EconPapers)
Date: 2016-05
New Economics Papers: this item is included in nep-mac
Note: AP CF EFG
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Citations: View citations in EconPapers (24)

Published as PEDRO BORDALO & NICOLA GENNAIOLI & ANDREI SHLEIFER, 2018. "Diagnostic Expectations and Credit Cycles," The Journal of Finance, vol 73(1), pages 199-227.

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Journal Article: Diagnostic Expectations and Credit Cycles (2018)
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