Working Paper: NBER ID: w28416
Authors: Pedro Bordalo; Nicola Gennaioli; Andrei Shleifer; Stephen J. Terry
Abstract: We incorporate diagnostic expectations into a workhorse neoclassical business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnostic overreaction estimated from US firm forecasts generates economic fragility during good times, countercyclical credit spreads, and boom-bust credit cycles at the firm and aggregate levels. Good times predict future disappointment, spread increases, low bond returns, and investment declines. To generate the size of spread increases observed during 2008-9, the model requires only disappointment of overoptimistic beliefs rather than large negative shocks. Diagnostic expectations offer a realistic, parsimonious way to produce financial reversals in business cycle models.
Keywords: No keywords provided
JEL Codes: E03; E32; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Managers' expectations of future profits overreact to current conditions (E32) | Excessive optimism in good times (E32) |
| Excessive optimism in good times (E32) | Future increases in credit spreads (G19) |
| Excessive optimism in good times (E32) | Lower realized bond returns (G12) |
| Excessive optimism in good times (E32) | Declines in investment growth (E22) |
| Excessive optimism in good times (E32) | Negative earnings surprises in the following year (G17) |
| Overreaction in managers' expectations (D84) | Boom-bust cycles in credit markets (E32) |
| Disappointment of overoptimistic beliefs (D84) | Economic fragility (F65) |
| Belief overreaction (G41) | Financial instability (F65) |