Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer, Stephen Terry
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)