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Diagnostic Business Cycles

Publication ,  Journal Article
Bianchi, F; Ilut, C; Saijo, H
Published in: Review of Economic Studies
January 1, 2024

A large psychology literature argues that, due to selective memory recall, decision-makers' forecasts of the future are overly influenced by the perceived news. We adopt the diagnostic expectations (DE) paradigm [Bordalo et al. (2018), Journal of Finance, 73, 199-227] 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 (1) the theoretical challenges associated with modelling the feedback between optimal actions and agents' DE beliefs and (2) 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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Published In

Review of Economic Studies

DOI

EISSN

1467-937X

ISSN

0034-6527

Publication Date

January 1, 2024

Volume

91

Issue

1

Start / End Page

129 / 162

Related Subject Headings

  • Economics
  • 3803 Economic theory
  • 3802 Econometrics
  • 3801 Applied economics
  • 14 Economics
 

Citation

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Bianchi, F., Ilut, C., & Saijo, H. (2024). Diagnostic Business Cycles. Review of Economic Studies, 91(1), 129–162. https://doi.org/10.1093/restud/rdad024
Bianchi, F., C. Ilut, and H. Saijo. “Diagnostic Business Cycles.” Review of Economic Studies 91, no. 1 (January 1, 2024): 129–62. https://doi.org/10.1093/restud/rdad024.
Bianchi F, Ilut C, Saijo H. Diagnostic Business Cycles. Review of Economic Studies. 2024 Jan 1;91(1):129–62.
Bianchi, F., et al. “Diagnostic Business Cycles.” Review of Economic Studies, vol. 91, no. 1, Jan. 2024, pp. 129–62. Scopus, doi:10.1093/restud/rdad024.
Bianchi F, Ilut C, Saijo H. Diagnostic Business Cycles. Review of Economic Studies. 2024 Jan 1;91(1):129–162.
Journal cover image

Published In

Review of Economic Studies

DOI

EISSN

1467-937X

ISSN

0034-6527

Publication Date

January 1, 2024

Volume

91

Issue

1

Start / End Page

129 / 162

Related Subject Headings

  • Economics
  • 3803 Economic theory
  • 3802 Econometrics
  • 3801 Applied economics
  • 14 Economics