Why Diagnostic Expectations Cannot Replace REH

22 Pages Posted: 3 Feb 2022

See all articles by Roman Frydman

Roman Frydman

New York University (NYU) - Department of Economics

Halina Frydman

New York University (NYU) - Department of Information, Operations, and Management Sciences

Date Written: January 18, 2022

Abstract

Gennaioli and Shleifer (GS) have proposed diagnostic expectations (DE) as an empirically-based approach to specifying participants’ expectations, which, like REH, can be applied in every model. Beyond its supposedly general applicability, GS’s formalization of DE implies that participants systematically and predictably overreact to news. Here, we present a formal argument that Kahneman and Tversky’s compelling empirical findings, and those of other behavioral economists, do not provide a basis for a general approach to specifying participants’ 'predictable errors'. We also show that the overreaction of participants’ expectations is not a regularity, but rather an artifact of GS’s particular specification of DE.

Keywords: Rational Expectations Hypothesis, Diagnostic Expectations, Representativeness Heuristic

JEL Classification: D80, D84, E71

Suggested Citation

Frydman, Roman and Frydman, Halina, Why Diagnostic Expectations Cannot Replace REH (January 18, 2022). Institute for New Economic Thinking Working Paper Series No. 175, Available at SSRN: https://ssrn.com/abstract=4023750

Roman Frydman (Contact Author)

New York University (NYU) - Department of Economics ( email )

19 West 4th Street
New York, NY 10012
United States

Halina Frydman

New York University (NYU) - Department of Information, Operations, and Management Sciences ( email )

44 West Fourth Street
New York, NY 10012
United States
212-998-0453 (Phone)

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