Finance Research Seminar - Stephen Terry

Real Credit Cycles

Pedro Bordalo (University of Oxford)

Nicola Gennaioli (Università Bocconi)

Andrei Shleifer (Harvard University)

Stephen J. Terry (Boston University)

We incorporate diagnostic expectations into a workhorse neoclassical business cycle model with heterogeneous firms and risky debt. A realistic degree of diagnostic over reaction estimated from US firm forecasts generates economic fragility during good times, countercyclical credit spreads, and boom-bust credit cycles at the firm and aggregate levels. Good times predict future disappointment, spread increases, low bond returns, and investment declines. To generate the size of spread increases observed during 2008-9, the model requires only disappointment of overoptimistic beliefs rather than large negative shocks. Diagnostic expectations offer a realistic, parsimonious way to produce financial reversals in business cycle models.