NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Diagnostic Expectations and Credit Cycles

Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer

NBER Working Paper No. 22266
Issued in May 2016
NBER Program(s):Asset Pricing, Corporate Finance, Economic Fluctuations and Growth

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.

download in pdf format
   (604 K)

email paper

Supplementary materials for this paper:

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w22266

Users who downloaded this paper also downloaded* these:
Barberis, Greenwood, Jin, and Shleifer w21944 Extrapolation and Bubbles
Baron and Xiong w22695 Credit Expansion and Neglected Crash Risk
Geanakoplos The Leverage Cycle
López-Salido, Stein, and Zakrajšek w21879 Credit-Market Sentiment and the Business Cycle
Jordà, Schularick, and Taylor w22743 Macrofinancial History and the New Business Cycle Facts
 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us