Diagnostic Expectations and Credit Cycles

Bordalo, Pedro, Gennaioli, Nicola and Shleifer, Andrei (2017) Diagnostic Expectations and Credit Cycles. Journal of Finance. pp. 1-57. (Accepted)

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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.

Item Type: Article
Keywords: finance
Subject(s): Finance
Date Deposited: 28 Mar 2017 13:49
Last Modified: 10 Jul 2017 10:17
Funders: not applicable
URI: http://eureka.sbs.ox.ac.uk/id/eprint/6318

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