Working Paper: NBER ID: w28604
Authors: Francesco Bianchi; Cosmin L. Ilut; Hikaru Saijo
Abstract: A large psychology literature argues that, due to selective memory recall, decision-makers' forecasts of their future circumstances appear overly influenced by the new information embedded in their current circumstances. We adopt the diagnostic expectations (DE) paradigm (Bordalo et al. (2018)) to capture this feature of belief formation and develop the behavioral foundations for applying DE to business cycle models, while demonstrating its empirical relevance for aggregate dynamics. First, we address (i) the theoretical challenges associated with modeling the feedback between optimal actions and agents' DE beliefs and (ii) the time-inconsistencies that arise under distant memory. Second, we show that under distant memory the interaction between actions and DE beliefs naturally generate repeated boom-bust cycles in response to a single initial shock. Finally, we propose a portable solution method to study DE in dynamic stochastic general equilibrium models and use it to estimate a quantitative DE New Keynesian model. Both endogenous states and distant memory play a critical role in successfully replicating the boom-bust cycle observed in response to a monetary policy shock.
Keywords: diagnostic expectations; business cycles; behavioral economics; monetary policy
JEL Codes: D8; D9; E0; E3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| distant memory (Y60) | interaction between actions and DE beliefs (C99) |
| interaction between actions and DE beliefs (C99) | repeated boom-bust cycles (E32) |
| initial shock (Y20) | repeated boom-bust cycles (E32) |
| DE paradigm (D50) | replicates empirical observations of boom-bust cycles (E32) |
| DE paradigm (D50) | persistent and hump-shaped responses in consumption (E21) |
| MPC out of temporary income shocks (E19) | higher under DE (I25) |
| degree of diagnosticity and distant memory (D80) | amplify effects of DE (C92) |