Diagnostic Business Cycles

Abstract

A large psychology literature argues that, due to selective memory recall, decisionmakers' forecasts of the future are overly inuenced by the perceived news. We adopt the diagnostic expectations (DE) paradigm (Bordalo et al. (2018)) to capture this feature of belief formation, develop a method to incorporate DE in business cycle models, and study the implications 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 (i.e. when news is perceived with respect to a more distant past than just the immediate one). Second, we show that under distant memory the interaction between actions and DE beliefs naturally generates repeated boom-bust cycles in response to a single initial shock. We also 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.

Incorporating Diagnostic Expectations into the New Keynesian Framework

“…In parallel and complementary work, Bianchi, Ilut, and Saijo (2022) also investigate applications of DE in linear models. Although their work, like ours, is comprehensive, the main focus of their paper is distant memory, the notion that agents' reference distribution looks back more than one period.…”

Understanding Persistent ZLB: Theory and Assessment

“…We followBianchi, Ilut andSaijo (2023) andL'Huillier, Singh andYoo (2023) in their approach to solving diagnostic expectations in linear general equilibrium settings.23 Angeletos, Huo and Sastry (2020, Sec. 6.4) show that leading departures from rational expectations such as level-k thinking, dogmatic higher-order beliefs, and cognitive discounting imply under-extrapolation.…”