Incorporating Diagnostic Expectations into the New Keynesian Framework.

This article focuses on integrating diagnostic expectations (DE)—a behavioral model of inference based on the representativeness heuristic—into the New Keynesian (NK) macroeconomic framework. It demonstrates analytically and empirically that DE generate endogenous extrapolation of shocks, leading to amplified business cycle fluctuations, Keynesian supply shocks, and larger fiscal multipliers in the presence of nominal rigidities. Using Bayesian estimation of a medium-scale DSGE model with U.S. data and Survey of Professional Forecasters forecasts, the study finds empirical support for DE, showing improved model fit and reduced reliance on noise shocks compared to rational expectations (RE) models. The findings suggest that DE provide a realistic and tractable alternative to RE, offering new propagation mechanisms that enhance the understanding of macroeconomic volatility and policy effectiveness.