Diagnostic Expectations and Credit Cycles

Bordalo, Pedro, Gennaioli, Nicola and Shleifer, Andrei (2018) Diagnostic Expectations and Credit Cycles. Journal of Finance, 73 (1). pp. 199-227.

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We present a model of credit cycles arising from diagnostic expectations—a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact 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: 03 Oct 2018 09:13
Funders: not applicable
URI: http://eureka.sbs.ox.ac.uk/id/eprint/6318

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