Working Paper: NBER ID: w22266
Authors: Pedro Bordalo; Nicola Gennaioli; Andrei Shleifer
Abstract: 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.
Keywords: Credit Cycles; Expectations; Behavioral Economics
JEL Codes: E03; E17; E32; G01; G02
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit spreads (G12) | volatility (E32) |
| news (Y60) | credit spreads (G12) |
| credit spreads (G12) | predictable reversals (G41) |
| optimistic beliefs (D84) | credit spreads (G12) |
| pessimistic beliefs (D91) | credit spreads (G12) |
| credit expansion (E51) | economic downturns (F44) |
| good news (Y60) | credit spreads (G12) |
| bad news (Y70) | credit spreads (G12) |
| current low spreads (G19) | upward revisions in future forecasts (C53) |
| high spreads (F31) | downward revisions (E01) |