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Incorporating Diagnostic Expectations into the New Keynesian Framework

Author

Listed:
  • Jean-Paul L’Huillier
  • Sanjay R Singh
  • Donghoon Yoo

Abstract

Diagnostic expectations constitute a realistic behavioural model of inference. This paper shows that this approach to expectation formation can be productively integrated into the New Keynesian framework. 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. We perform Bayesian estimation of a rich medium-scale model that incorporates consensus forecast data. Our estimate of the diagnosticity parameter is in line with previous studies. Moreover, we find empirical evidence in favour of the diagnostic model. Diagnostic expectations offer new propagation mechanisms to explain fluctuations.

Suggested Citation

  • Jean-Paul L’Huillier & Sanjay R Singh & Donghoon Yoo, 2024. "Incorporating Diagnostic Expectations into the New Keynesian Framework," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 91(5), pages 3013-3046.
    • Handle: RePEc:oup:restud:v:91:y:2024:i:5:p:3013-3046.
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    File URL: http://hdl.handle.net/10.1093/restud/rdad101
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    Keywords

    Heuristics; Representativeness; General equilibrium; Shocks; Volatility;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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