Real Credit Cycles

By: Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer and Stephen J. Terry

Format:Print
| Language:English

Abstract

We incorporate diagnostic expectations, a psychologically founded model of overreaction to news, into a workhorse business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnosticity, estimated from the forecast errors of managers of U.S. listed firms, creates financial fragility during good times. This mechanism produces countercyclical credit spreads and yields two key features of observed credit cycles. First, it generates boom-bust dynamics at the firm and aggregate levels: cheap credit predicts future increases in spreads, low bond returns, and investment drops. Second, it produces the spike in spreads observed in 2008–9 from modest negative TFP shocks. Diagnostic expectations offer a parsimonious mechanism generating realistic financial reversals in conventional business cycle models.