Abstract. We derive the theoretical predictions of diagnostic expectations regarding the transmission of sentiment to investment, employment, income, and consumption under imperfect information. We show and verify that, unlike rational expectations, diagnostic expectations predict short-term overreaction and subsequent reversals particularly in economies characterized by low financial sophistication. These effects are stronger when macroeconomic uncertainty is high and sentiment volatility is low. Using several empirical measures of sentiment and uncertainty, we find evidence consistent with these predictions both in a cross-section of OECD countries and in US time-series data. Finally, we identify the transmission mechanism of expectations to the economy.
Coauthor. George Constantinides (University of Chicago).
Manuscript. You can find the latest draft here.
Presentations. International Conference on Empirical Economics at Pennsylvania State University, Behavioral Finance Working Group conference, Utrecht University, University of Edinburgh, University of Glasgow.
Awards. Elsevier's best empirical paper award at the 2025 Behavioral Finance Working Group conference.