Real Credit Cycles
We incorporate diagnostic expectations, a psychologically founded model of overreaction to news, into a workhorse business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnosticity, estimated from the forecast errors of managers of US listed firms, creates financial fragility during good times. This mechanism produces countercyclical credit spreads and yields two key features of observed credit cycles. First, it generates boom-bust dynamics at the firm and aggregate levels: cheap credit predicts future increases in spreads, low bond returns, and investment drops. Second, it produces the spike in spreads observed in 2008-9 from modest negative TFP shocks. Diagnostic expectations offer a parsimonious mechanism generating realistic financial reversals in conventional business cycle models.
We thank audiences at FRB Minneapolis, Yale Finance, Harvard Business School Finance, NBER Behavioral Macro, Northwestern Kellogg Finance, Stanford SITE Uncertainty, NHH, the European Central Bank, Boston University, Harvard Economics, NBER Impulse and Propagation Mechanisms, the AEAs, Queen Mary University of London, the Econometric Society, and CREi-UPF, our discussants Alp Simsek and Cosmin Ilut, as well as Spencer Kwon, for valuable comments and suggestions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.