Real Credit Cycles

This paper incorporates diagnostic expectations — beliefs that overweight the representativeness of recent data, formalized as $E_t^\theta(A_{t+1}) = E_t(A_{t+1}) + \theta[E_t(A_{t+1}) - E_{t-1}(A_{t+1})]$ with θ > 0 — into a workhorse real business cycle model with heterogeneous firms and risky defaultable debt, to assess whether non-rational belief overreaction can account for boom-bust credit cycles without requiring large fundamental shocks. The diagnosticity parameter θ is structurally estimated via simulated method of moments, targeting moments including forecast-error predictability from the IBES manager guidance database, and yields θ ≈ 0.991, consistent with prior estimates from financial analysts and professional forecasters. The estimated DE model generates several untargeted results that the rational-expectations (RE) benchmark cannot: countercyclical credit spreads, predictable firm-level bond returns, and investment fragility in good times — specifically, a one-standard-deviation negative TFP shock causes a much larger investment decline when the previous period had good TFP news than in normal times. The model also shows that the 2008-09 spread increase can be generated by mere disappointment of overoptimistic beliefs, not requiring a large negative TFP shock. These findings establish diagnostic expectations as a parsimonious and empirically disciplined mechanism for producing financial reversals in business cycle models.

Stephen J. Terry | Macro Paper Warehouse

Real Credit Cycles