Incorporating Diagnostic Expectations into the New Keynesian Framework

L’Huillier, Jean-Paul; Singh, Satnam; Yoo, Donghoon

doi:10.2139/ssrn.3910318

SSRN Journal

2021

DOI: 10.2139/ssrn.3910318

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Incorporating Diagnostic Expectations into the New Keynesian Framework

Jean-Paul L’Huillier

Satnam Singh

Donghoon Yoo

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“…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.…”

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confidence: 99%

Understanding Persistent ZLB: Theory and Assessment

Cuba-Borda,

Singh

2024

ERWP

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We develop a theoretical framework that rationalizes two hypotheses of long-lasting low interest rate episodes: deflationary-expectations-traps and secular stagnation in a unified setting. These hypotheses differ in the sign of the theoretical correlation between inflation and output growth that they imply. Using the data from Japan over 1998:Q1-2019:Q4, we find that the data favor the expectations-trap hypothesis. The superior model fit of the expectations trap relies on its ability to generate the observed negative correlation between inflation and output growth.

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confidence: 99%

Understanding Persistent ZLB: Theory and Assessment

Cuba-Borda,

Singh

2024

ERWP

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Angeletos

2024

NBER Macroeconomics Annual

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Diagnostic Business Cycles

Bianchi

Ilut

Saijo

2023

Review of Economic Studies

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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.

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Incorporating Diagnostic Expectations into the New Keynesian Framework

Cited by 3 publications

References 31 publications

Understanding Persistent ZLB: Theory and Assessment

Understanding Persistent ZLB: Theory and Assessment

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Diagnostic Business Cycles

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