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):AP, CF, EFG

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.

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Document Object Identifier (DOI): 10.3386/w22266

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