Template-Type: ReDIF-Paper 1.0
Author-Name: Jean-Paul L'Huillier
Author-Name-First: Jean-Paul
Author-Name-Last: L'Huillier
Author-Name: Sanjay R. Singh
Author-Name-First: Sanjay R.
Author-Name-Last: Singh
Author-Name: Donghoon Yoo
Author-Name-First: Donghoon
Author-Name-Last: Yoo
Author-Workplace-Name: Department of Economics, University of California Davis
Title: Incorporating Diagnostic Expectations into the New Keynesian Framework
Abstract: Diagnostic expectations constitute a realistic behavioral model of inference. This paper shows that this approach for expectation formation can be productively integrated into the New Keynesian framework. To this end, we start by offering a first technical treatment of diagnostic expectations in linear macroeconomic models. Diagnostic expectations generate endogenous extrapolation in general equilibrium. We show that diagnostic expectations generate extra amplification in the presence of nominal frictions; a fall in aggregate supply generates a Keynesian recession; fiscal policy is more effective at stimulating the economy; with imperfect information, diagnostic expectations generate delayed overreaction of aggregate variables. Bayesian estimation of a rich medium-scale model delivers estimates of the diagnosticity parameter that is in line with previous studies. Moreover, we find strong empirical evidence in favor of the diagnostic model.
Length: 89
File-URL: https://repec.dss.ucdavis.edu/files/icuBxv4zXCH2wR1pdpuZHegA/DE_NK%205.3%20Aug%202021.pdf
File-Format: application/pdf
Number: 339
Classification-JEL: E12, E32, E71
KeyWords: diagnostic expectations, macroeconomics, volatility, linear rational expectations, overshooting
Creation-Date: 20210209
Handle: RePEc:cda:wpaper:339