Diagnostic Expectations and Credit Cycles

By P. Bordalo, N. Gennaioli, A. Shleifer. A Crisis of Beliefs, 2018

461 citations recorded by the source corpus.

We present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. In this formulation, when forming their beliefs agents overweight future outcomes that have become more likely in light of incoming data. The model reconciles extrapolation and neglect of risk in a unified framework. Diagnostic expectations are forward looking, and as such are immune to the Lucas critique and nest rational expectations as a special case. In our model of credit cycles, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.

Subfields: Finance

View Paper: https://www.semanticscholar.org/paper/c9b71523a72d6b4abaccc7175510e562abafead4

How researchers see this paper

The researchers whose trusted networks rank it highest, strongest advocate first. Every researcher gets a different order.

In Finance

Citations in the corpus

Predictable Financial Crises (2020, result): “Our findings favor the Kindleberger-Minsky view of credit cycles and financial crises, formalized in recent theoretical models such as Bordalo, Gennaioli, and Shleifer (2018), Gennaioli and Shleifer (2018), Greenwood, Hanson, and Jin (2019), Maxted (2020), and Krishnamurthy and Li (2020).”
How Does Credit Supply Expansion Affect the Real Economy? The Productive Capacity and Household Demand Channels (2020, unknown): “Or alternatively, there may be reallocation of labor away from tradable sector firms toward less productive firms producing non-tradable goods (Borio et al. (2016)).”
Racial Bias in Bail Decisions ⇤ (2018, unknown): “[20] Bordalo, Pedro, Nicola Gennaioli, and Andrei Shleifer, “Diagnostic Expectations and Credit Cycles,” Journal of Finance, 73 (2018), 199-227.”
The Formation of Expectations, Inflation, and the Phillips Curve (2018, background): “and Bordalo et al. (2016) take this behavioral intuition and formalize it into diagnostic expectations.”
Diagnostic Expectations and Stock Returns (2019, methodology): “As we discuss in Bordalo, Gennaioli, and Shleifer (2018), two alternative specifications may be relevant.”
Credit-Market Sentiment and the Business Cycle (2017, unknown): “…literature in behavioral finance, which analyzes the dynamics of asset prices when some investors update their beliefs in a not-fullyrational manner.4 Two recent contributions in this vein are Bordalo, Gennaioli, and Shleifer (2016), hereafter BGS, and Greenwood, Hanson, and Jin (2016), or GHJ.”
Psychology-based Models of Asset Prices and Trading Volume (2018, methodology): “Bordalo et al. (2017) and Bordalo et al. (2018a) incorporate this belief distortion into a dynamic framework they call “diagnostic expectations.””