Events at CERGE-EI

Pedro Bordalo, Ph.D.

Royal Holloway University London, United Kingdom

Authors: Pedro Bordalo, Nicola Gennaioli, and Andrei Shleifer

Abstract: We present a model of credit cycles based on a new psychological formulation of the expectations mechanism. Agents form “stereotypical” expectations whereby they over-weight, in their belief revisions, the future outcomes that have become more likely in light of incoming data. This model of context dependent beliefs is based on a formalization of Kahneman and Tversky’s representativeness heuristic that has been previously used to explain a substantial amount of experimental evidence in psychology as well as the social phenomenon of stereotyping. Beliefs in this formulation are forward looking, immune to the Lucas critique, and contain rational expectations as a special case. Beliefs exhibit excess volatility, over-reaction to news, and systematic reversals. These dynamics account for many recently documented features of credit cycles and macroeconomic volatility without resort to financial frictions. In particular, they generate systematic reversion of a financial boom into a bust in the absence of deteriorating fundamentals.

Full Text:  “Investor Psychology and Credit Cycles”