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The study aims to develop a model explaining how diagnostic expectations influence credit cycles.

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September 26, 2017Open Access

Diagnostic Expectations and Credit Cycles

Key Points

The study aims to develop a model explaining how diagnostic expectations influence credit cycles.
Development of a model based on Kahneman and Tversky's representativeness heuristic.
Analysis of the implications of forward-looking expectations under a stochastic process.
Integration of extrapolation and risk neglect to study credit spread behavior.
Credit spreads demonstrated excessive volatility and overreaction to news.
Model dynamics lead to predictable reversals in credit cycles.
Findings explain several aspects of macroeconomic volatility.

Abstract

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.

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