Diagnostic Expectations and the Macroeconomy

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 the macroeconomy is more uncertain and sentiment is less uncertain. Using several empirical measures of sentiment and macroeconomic 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.