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Diagnostic expectations and credit cycles

Abstract:
We present a model of credit cycles arising from diagnostic expectations—a belief formation mechanism based on Kahneman and Tversky's representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, and thus is immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, overreact to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.
Publication status:
Published
Peer review status:
Peer reviewed

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Files:
Publisher copy:
10.1111/jofi.12586

Authors

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Institution:
University of Oxford
Division:
SSD
Department:
Said Business School
Oxford college:
Kellogg College
Role:
Author

More from this funder
Funder identifier:
https://ror.org/0472cxd90
Funding agency for:
Gennaioli, N
Grant:
647782

Publisher:
Wiley
Journal:
Journal of Finance More from this journal
Volume:
73
Issue:
1
Pages:
199-227
Publication date:
2018-01-26
Acceptance date:
2017-02-22
DOI:
EISSN:
1540-6261
ISSN:
0022-1082

Language:
English
Pubs id:
pubs:684117
UUID:
uuid:a78deb53-6193-41e8-b5ff-50647f4e7263
Local pid:
pubs:684117
Source identifiers:
684117
Deposit date:
2017-03-07
ARK identifier:

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