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Review of Economic Studies Vol. 91 No. 5 2024

Incorporating Diagnostic Expectations into the New Keynesian Framework

Jean-Paul L’Huillier1; Sanjay R Singh2; Donghoon Yoo3

1 Federal Reserve Bank of Cleveland and Department of Economics, Brandeis University , USA · 2 Federal Reserve Bank of San Francisco and Department of Economics, University of California Davis , USA · 3 Institute of Economics, Academia Sinica, Taiwan; Institute of Social and Economic Research, Osaka University , Japan

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.

DOI
10.1093/restud/rdad101
Volume
91
Issue
5
Pages
3013-3046
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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