Learning, Diagnostic Expectations and Financial Crisis

Abstract

We develop a continuous-time macro-finance model in which agents learn about a latent component of TFP growth and form diagnostic expectations. Learning attenuates the immediate response to permanent shocks but makes transitory shocks move beliefs, creating a hidden belief–fundamental wedge that affects crisis risk. Diagnostic expectations generate a stabilization paradox. They reduce unconditional crisis frequency, duration, and average output losses by raising required risk compensation in downturns and accelerating expert recapitalization. Yet they increase fragility along tranquil histories by encouraging leverage and weakening balance sheet strength after favorable news. We identify a class of Minsky-style crises: downturns preceded by prolonged optimism and apparent calm and triggered by modest adverse shocks. A 2007–2008 exercise shows that the model can generate pre-crisis optimism, a buildup in credit to GDP, and abrupt output losses.

Keywords: learning, diagnostic expectation, Minsky crisis, financial crisis