What question did this study set out to answer?

This research investigates how diagnostic expectations affect credit cycles in a neoclassical model with various firms and risky debt.

April 1, 2026

Real Credit Cycles

Key Points

This research investigates how diagnostic expectations affect credit cycles in a neoclassical model with various firms and risky debt.
Embedded diagnostic expectations in a neoclassical economic model.
Analyzed the impact of US firms’ earnings forecasts.
Examined the effect of moderate negative shocks on credit spreads.
Generated realistic credit cycles reflecting historical data.
Demonstrated that good times can lead to economic fragility.
Showed that moderate negative shocks can produce significant increases in credit spreads.

Abstract

We embed diagnostic expectations in a workhorse neoclassical model with heterogeneous firms and risky debt. A realistic degree of overreaction estimated from US firms’ earnings forecasts generates realistic credit cycles. Good times produce economic and financial fragility, predicting future disappointment of expectations, low bond returns, and investment declines. To generate the size of spread increases observed during 2007–2009, the model requires only moderate negative shocks. Diagnostic expectations offer a realistic, parsimonious way to produce financial reversals in business cycle models. (JEL D84, E13, E22, E32, E44, G12, G32)

Mark Helpful

Bookmark

Relay