Overreaction and Diagnostic Expectations in Macroeconomics
We present the case for the centrality of overreaction in expectations for addressing important challenges in finance and macroeconomics. First, non-rational expectations by market participants can be measured and modeled in ways that address some of the key challenges posed by the rational expectations revolution, most importantly the idea that economic agents are forward-looking. Second, belief overreaction can account for many long-standing empirical puzzles in macro and finance, which emphasize the extreme volatility and boom-bust dynamics of key time series, such as stock prices, credit, and investment. Third, overreaction relies on psychology and is disciplined by survey data on expectations. This suggests that relaxing the assumption of rational expectations is a promising strategy, helps theory and evidence go together, and offers a unified view of a great deal of data.
We are deeply grateful to Spencer Kwon, Pierfrancesco Mei, and Johnny Tang for help with the paper. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2022. "Overreaction and Diagnostic Expectations in Macroeconomics," Journal of Economic Perspectives, American Economic Association, vol. 36(3), pages 223-244, Summer. citation courtesy of
Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 2022. "Overreaction and Diagnostic Expectations in Macroeconomics," Journal of Economic Perspectives, vol 36(3), pages 223-244.