Essays on belief-driven macroeconomic volatility and expectation formation

Montenegro Calvimonte, Marcos Gaspar (2025) Essays on belief-driven macroeconomic volatility and expectation formation. PhD thesis, University of Glasgow.

Abstract

This thesis investigates macroeconomic volatility through the lens of expectation formation, emphasising the role of belief-driven mechanisms. In particular, I explore the implications of incorporating Diagnostic Expectations (DE), a recent deviation from the standard rationality assumption, into macroeconomic models.

The first chapter embeds DE into a Small Open Economy framework à la Justiniano and Preston (2010), a benchmark model for analysing exchange rate dynamics. Recent studies show that DE generate excess volatility, short-term extrapolative behaviour and predictable shifts in investor sentiment, characteristics that align with puzzles in international macroeconomics, particularly excess exchange rate volatility and exchange rate disconnect (Obstfeld & Rogoff, 2000). For this reason, DE emerge naturally as a possible behavioural explanation for these phenomena. In this chapter, I leverage the international finance nature of the economy to study the interaction between DE and the exchange rate transmission channel, which is otherwise absent in a closed economy. I parameterise the model following the open economy literature and show that when the model is populated with diagnostic agents, the economy exhibits greater volatility vis `a vis the rational model. Moreover, DE introduce an amplification mechanism through shock extrapolation, which helps to qualitatively account for the excess volatility of the real exchange rate and its disconnection from fundamentals. The degree of departure from Rational Expectations (RE), captured by the diagnostic parameter, plays a central role in this extrapolation mechanism, with larger values amplifying the effect. I also use the model to assess the sensitivity of the results to different parameter values. The main finding highlights that economic openness and DE do not operate in isolation; rather, they amplify each other’s effects. In addition, I show that persistence mechanisms, especially interest rate smoothing, are essential for translating and intensifying the amplification effect of DE into short-run macroeconomic dynamics.

The second chapter expands the study of DE within macroeconomic models, now concentrating on the housing sector. Empirical evidence from the U.S. reveals that the housing market exhibits an unusually high degree of volatility, with survey-based expectations displaying biases that challenge the rationality assumption. In addition, tradition models often depend on volatile housing preference shocks to account for these fluctuations. In this chapter, I argue that the expectations channel plays a key role in driving housing market volatility. I incorporate DE into a Two-Agent New Keynesian (TANK) model featuring a housing and a banking sector to analyse the impact of this departure from rationality. I calibrate some parameters to the U.S. economy for the post-Volker - pre-Covid 19 pandemic period and estimate the remaining parameters using Sequential Monte Carlo methods. I find that DE reduce the volatility of the housing preference shock by more than one-third relative to RE, while still reproducing the observed housing market fluctuations. This result holds regardless of whether agents’ imperfect memory is based on recent or on three-year past experiences. When the expectations channel is removed, that is, when agents become rational, the model fails to generate the high volatility in house prices found in the data. These findings emphasise the importance of the expectations formation process for explaining a substantial part of the “unmodeled disturbances that can affect the housing market”, which Iacoviello and Neri (2010) attribute to a housing preference shock, and in shaping policy responses.

The third chapter extends the previous analyses by further demonstrating the effects of incorporating DE into macroeconomic models. Survey evidence, first presented by Coibion and Gorodnichenko (2015), sparked a broader discussion on deviations from the Full Information Rational Expectations (FIRE) framework (Fuhrer, 2018; Angeletos, Huo, & Sastry, 2021; Kohlhas & Walther, 2021). Specifically, Coibion and Gorodnichenko (2015) find that Forecast Errors (FE) and Forecast Revisions (FR) are predictable, suggesting that agents do not fully incorporate available information, a challenge to the FIRE hypothesis. In this chapter, I explore the impact of DE on the state-space structure of linear macroeconomic models and the resulting FE and FR across different horizons. In a three-equation specification, I derive testable expressions in terms of the model parameters and also generalise it to the case of larger models. I find that DE introduce predictability in the form of moving average (MA) processes. To assess whether expectation formation differs across agents, I analyse survey data from the Philadelphia Fed’s Survey of Professional Forecasters alongside policymakers’ forecasts from the Greenbook/Tealbook. The empirical results indicate that one-period-ahead FE generally follow the MA structures implied by DE, though evidence of overreaction appears only for GDP growth forecasts and primarily when including the post-pandemic period. Mixed results are, however, observed in the case of FR. For longer forecast horizons, FE include autoregressive components deviating from DE, whereas FR align more closely with DE-driven expectations, suggesting stronger revisions in the direction of the shock realisation. While these results provide insights into belief formation, they remain far from conclusive.

• Item Type: Thesis (PhD)
• Qualification Level: Doctoral
• Subjects: H Social Sciences > HB Economic Theory
• Colleges/Schools: College of Social Sciences > Adam Smith Business School > Economics
• Supervisor's Name: Dennis, Professor Richard and Moldovan, Dr. Ioana
• Date of Award: 2025
• Depositing User: Theses Team
• Unique ID: glathesis:2025-85249
• Copyright: Copyright of this thesis is held by the author.
• Date Deposited: 24 Jun 2025 13:09
• Last Modified: 24 Jun 2025 13:11
• Thesis DOI: 10.5525/gla.thesis.85249
• URI: https://theses.gla.ac.uk/id/eprint/85249

Related URLs

• https://mgmontenegrocal.github.io/public...