MACRO: Overreaction and Macroeconomic Fluctuation of the External Balance; Dr Donghoon Yoo (Institute of Economics, Academia Sinica)

Abstract

In this paper, we integrate diagnostic decision-makers into dynamic open macro models. We show how diagnostic expectations (DE) can generate countercyclical movements of trade balances as well as the boom-bust cycles of cross-border capital flows. The DE channel introduces an endogenous cognitive dimension to the aggregate fluctuations in the open economy, in contrast to the rational expectations (RE) approach, which has traditionally relied on financial wedges to explain similar features. On the empirical front, using more than a century of Argentine data, we perform Bayesian estimation of the open economy business cycle model armed with various shocks and frictions under DE. Our findings reveal a significant degree of diagnosticity, which is consistent with existing literature. We also show that the DE channels endogenously absorb business cycle fluctuations pertaining to the external balance and other aggregate variables, which were previously attributed to exogenous financial shocks originating from international financial markets.