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Diagnostic Business Cycles

Author

Listed:
  • Bianchi, Francesco
  • Ilut, Cosmin
  • Saijo, Hikaru
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.

Suggested Citation

  • Bianchi, Francesco & Ilut, Cosmin & Saijo, Hikaru, 2022. "Diagnostic Business Cycles," CEPR Discussion Papers 16005, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16005
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    Cited by:

    1. Constantin Bürgi & Julio L. Ortiz, 2022. "Overreaction through Anchoring," CESifo Working Paper Series 10193, CESifo.
    2. Jonathan J Adams, 2024. "Optimal Policy Without Rational Expectations: A Sufficient Statistic Solution," Working Papers 001011, University of Florida, Department of Economics.
    3. Pedro Bordalo & Nicola Gennaioli & Rafael La Porta & Matthew OBrien & Andrei Shleifer, 2024. "Long-Term Expectations and Aggregate Fluctuations," NBER Macroeconomics Annual, University of Chicago Press, vol. 38(1), pages 311-347.
    4. Alistair Macaulay, 2022. "Heterogeneous Information, Subjective Model Beliefs, and the Time-Varying Transmission of Shocks," CESifo Working Paper Series 9733, CESifo.
    5. George-Marios Angeletos, 2023. "Comment on "Long Term Expectations and Aggregate Fluctuations" 2," NBER Chapters, in: NBER Macroeconomics Annual 2023, volume 38, pages 348-362, National Bureau of Economic Research, Inc.

    More about this item

    Keywords

    Diagnostic expectations; Boom and bust cycles; beliefs;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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