Mais Macro (IV) - Parte 3, Crenças Heterogêneas

Heterogeneous Beliefs
Eduardo Zilberman
PUC-Rio
Macro IV - 2020.1
Heterogeneous Beliefs: Road Map
I Macro view (textbook approach). Reference: Ljungqvist and
Sargent, Appendices B and C to Chapter 8 in the new edition.
I Finance view (textbook approach). Reference: Campbell (2018),

Section 11.4.
I A few insights from surveys: Xiong (2013, Handbook) and

Scheinkman (2014, Arrow Lecture).
I Detour. Diagnostic expectations: Gennaioli and Shleifer (2018),

parts of Chapters 4, 5 and 6.
I Shameless self-promotion: “Speculation-Driven Business Cycles”,

Bigio and Zilberman (2020).

Section 11.4.



Heterogeneous Beliefs: Macro View
Setup in Ljungqvist and Sargent, Chapter 8 (complete markets, review):
1. Time: discrete, infinity (t = 0, 1, ...)
2. Population: I agents indexed by i = 1, ...., I
3. one homogeneous and perishable good
4. Information structure: aggregate uncertainty
I stochastic event: st ∈ S in each period t ≥ 0
I history of events up to t, s t = [s0 , s1 , ..., st ] ∈ S t
I unconditional probability: πt (s t ), com π0 (s0 ) = 1
I conditional probability: πt (s t |s τ )
I at t, s t is observable
5. Endowment/technology: stochastic, yti (s t ) unities of the good
6. Preferences: over consumption c i = {cti (s t )}∞
t=0
∞ X
X
U(c i ) = β t u[cti (s t )]πt (s t ),
t=0 s t
0 00
with u > 0, u < 0 and Inada.
I Strong assumption: same probabilities {πt (s t )} to all agents inside
the model, the outside observer (“the economist”) and the nature.
I “Communism of probability models” embraces the “rational expect
hypothesis,” eliminating all free parameters that describe beliefs.
I Came at a cost: combines and confounds distinct roles that actual
and perceived probabilities play to determine allocations and prices.
Big question. Is Alchian (1950) and Friedman (1953)’s conjecture (aka
natural selection hypothesis) true?
I.e., by redistributing wealth towards agents with more accurate beliefs,
market forces eventually make outcomes look like a RE equilibrium.
I Blume and Easley (1992, 2006); Sandroni (2000): yes, if markets
are complete and preferences are separable.
I Blume and Easley (2006); Beker and Chattopadhyay (2010); Cao
(2017): no, if markets are incomplete.
I Borovicka (2020); Dindo (2019): no, if markets are complete and
preferences are nonseparable recursive.
Modification: allow for heterogeneous beliefs and u, but homogeneous β.

∞ X
X
U i (c i ) = β t ui [cti (s t )]πti (s t )
t=0 s t
Goal. Solve the planner problem, which is something controversial in the

literature. After all, what beliefs to specify (more on that later)?
We assume that the planner respects each agent beliefs. The Welfare
Theorems remain valid, and we learn about equilibrium outcomes.
Given weights {λi }, the planner maximizes the social welfare function
I
X ∞ X
I X
X
W = λi U i (c i ) = λi β t ui [cti (s t )]πti (s t ),
i=1 i=1 t=0 s t
subject to the resources constraint for all t, s t ,

I
X I
X
cti (s t ) = yti (s t ).
i=1 i=1
FOCs of the Pareto problem (after building the Lagrangian) yield
ui0 (cti (s t )) λj πtj (s t )
= ,
uj0 (ctj (s t )) λi πti (s t )
πtj (s t )
Likelihood ratio Lijt (s t ) ≡ πti (s t )
influences optimal allocations. Indeed, at
t, s , planner assigns relatively more cti (s t ) for those with higher πti (s t ).
t
Definitions: Trader i ...

I vanishes in a given history if: lim cti (s t ) = 0;
I survives in a given history if: lim sup cti (s t ) > 0 (“sup” accounts for
the possibility that cti (s t ) fluctuates in the limit).
Lemma. If aggregate endowment is positive and finite, in a given history,

I if Lijt (s t ) → ∞ for some j, Inada implies that: lim cti (s t ) = 0;
I if cti (s t ) → 0, Inada implies that lim sup Lijt (s t ) = ∞ for some j.
I (“sup” accounts for the possibility that ctj (s t ) fluctuates in the
limit, and lim inf ctj (s t ) = 0).
Proposition. From trader i’s perspective, lim sup cti (s t ) > 0 almost surely,
i.e. he/she believes he/she survives almost surely.
Proof. Another application of the martingale convergence thm. Indeed,

j t
from trader i’s perspective, Lijt (s t ) ≡ ππti (s
(s )
t ) is non-negative martingale.
t
" j #
j
i πt+1 (s t+1 ) t X
i t+1 t πt+1 (s |s )πtj (s t )
t+1 t
πtj (s t )
E i
s = π t+1 (s |s ) i
= ,
(s t ) (s t+1 |s t )πti (s t ) πti (s t )

πt+1 t+1 t
πt+1
s |s
which converges almost surely. Hence, lim sup Lijt (s t ) = ∞ only holds at
a zero measure set of histories.
Corollary. If trader i has rational expectations, i.e. {πti (s t )} is equal to

the true probability model, say {πt (s t )}, he/she survives almost surely.
Natural questions: (i) what happens to other “non-rational” traders?; (ii)

what if a rational trader does not exist?
Natural questions: (i) what happens to other “non-rational” traders?; (ii)
what if a rational trader does not exist?
To answer these questions, simplify the environment.

I Two-states S = {0, 1}. True and forecast distributions are i.i.d.
I True distribution: Prob(st = 0) = α̃.
I Trader’s i forecast distribution: Prob(st = 0) = αi .
Results are generalizable.
Suppose a history s t in which s = 0 realized n times. Hence,

t−n n
πtj (s t )

ij t 1 − αj αj
Lt (s ) ≡ i t =
πt (s ) 1 − αi αi
Note limt→∞ n/t = α̃ (LLN). Hence, in the limit, for almost all s t ,
(1−α̃)t α̃t (1−α̃)t α̃t
1 − αj αj 1 − αj 1 − α̃ αj α̃
Lijt = =
1 − αi αi 1 − α̃ 1 − αi α̃ αi
Definition (detour): relative entropy of a probability distribution q on S
with respect to a probability distribution p on S,
X p(s)
Ep (q) = p(s) ln .
q(s)
s∈S
Properties: Ep (q) ≥ 0; Ep (q) = 0 if and only if q = p. It captures how

far q is from p through the lens of p, but it is not a metric.
With some abuse of notation, by taking logs, note that in the limit,
1
ln Lijt = Eα̃ (αi ) − Eα̃ (αj ) ⇒ Lijt = e [Eα̃ (αi )−Eα̃ (αj )]t ,
t
which diverges, i.e. limt→∞ Lijt = ∞ almost surely if Eα̃ (αi ) > Eα̃ (αj ).
Recall that, in a given history, lim Lijt (s t ) = ∞ implies lim cti (s t ) = 0.
Hence, whenever a trader j with more accurate beliefs than trader i

exists, i.e. Eα̃ (αi ) > Eα̃ (αj ), then trader i eventually vanishes.
In other words, only agents with the “more accurate” beliefs survive.
Exposition so far based on Appendix B in Chapter 8 (Ljungqvist and
Sargent, new edition), and Blume and Easley (2006, ECMA).
I We characterized some “survival” results implied by the optimal
allocation when beliefs are heterogeneous.
I First Welfare Theorem: with complete markets, results immediately
extend to a competitive equilibrium environment.
I Equilibrium prices embed correct probability assessments
asymptotically, formalizing the natural selection hypothesis.
I Intuition: why those with less accurate beliefs disappear? Inexorable
working of the law of large number ...
I From the Planner’s perspective, more consumption at the pair
time-history agents believes are more likely.
I In equilibrium, those with less accurate beliefs “pays too
much” (“receives too little”) for buying (selling) insurance.
I Over time, wealth goes to those with more accurate beliefs.
I Same forces drive outcomes when consumers can learn (i.e., update
beliefs over time). See Blume and Easley (2006).
Two modifications: anything can happen with ...
I ... recursive (nonseparable) preferences;
I ... incomplete markets.
Recursive preferences. Detour: Epstein and Zin (1989, 1991)

preferences. Two inputs: Ut = W (ct , µ[Ũt+1 |It ]), where
I ct is current consumption, which is deterministic;
I and µ[Ũt+1 |It ] is certainty equivalent of random future utility,
computed using the agent’s risk preferences.
Possibility to separate substitution (“encoded” in W ) from risk aversion
(“encoded” in µ). Example (allowing for heterogeneous beliefs):
( 1
) 1−1/ρ
h i 1−1/ρ
1−γ
1−1/ρ 1−γ
Ui,t = (1 − β)ci,t + βEi,t Ui,t+1 , where
I γ interpreted as relative risk aversion; ρ is the IES and β the

discount factor were the model deterministic.
I If γ = 1/ρ, standard separable preferences with CRRA utility.
Borovicka (2020). Counterpart of Epstein-Zin preferences in continuous

time due to Duffie and Epstein (1992). Two-agents, complete markets.
In terms of lung-run survival, anything can happen:

Comments:
I As before, in the neighborhood of γ = 1/ρ, the rational agent
dominates, and the natural selection hypothesis follows.
I In contrast to the natural selection hypothesis, for γ >>> 1/ρ
(empirically plausible), coexistence is possible (points A and B).
Intuition/forces at play:
I γ ↑ implies risk premium ↑, favoring the optimistic; but risk premium
falls as the optmistic accumulates wealth (counteracting force).
I If ρ > 1, saving rate increases with subjective expected portfolio
returns. This acts to preserve long-run coexistence.
I As prices reflect mainly the beliefs of the wealthy agent, the
other saves more due to beliefs that portfolios are underpriced.
I γ ↓ acts to eliminate coexistence. The poor agent chooses highly
volatile speculative portfolios with low expected returns.
Incomplete markets. With separable preferences, anything can happen.
I Co-existence is not surprising: binding debt limits prevents agents

with inaccurate beliefs from making huge mistakes,
I i.e. commit their entire flow of endowments to support past

consumption.
I Market structure matters. E.g., Cao (2017), in which agents are

also endowed with physical assets (trees).
I If only market for risk free bonds (subject to some debt limit),
precautionary motive favors the survival of pessimists.
I If only market for shares (subject to a short-selling constraint),
prosperity by speculation favors the survival of optimists.
I Somewhat more surprising: agents with correct beliefs may vanish.
Next: an example in which the agent with correct beliefs vanishes.

Example in Appendix C, Chapter 8 (Ljungqvist and Sargent, new

edition), based on Beker and Chattopadhyay (2010).
I Two agents, i = 1, 2: u1 (c) = c 1−γ

1−γ , with γ 6= 1, and u2 (c) = ln(c);
I for all t, s t , aggregate endowment Yt (s t ) > 0; and there exists

s t+1 |s t and s̃ t+1 |s t , such that Yt (s t+1 ) 6= Yt (s̃ t+1 );
I for all t, s t , individual endowments (y01 (s 0 ), y02 (s 0 )) = (0, Y0 (s 0 ))

and (yt1 (s t ), yt2 (s t )) = (Yt (s t ), 0) for t > 0 and all s t ;
I one asset available: zero net supply, exog. payoff µt+1 (st+1 , s t ) > 0
for all st+1 , traded sequentially at price pt (s t ) for all t, s t .
Example in Appendix C, Chapter 8 (Ljungqvist and Sargent, new
edition), based on Beker and Chattopadhyay (2010).
Trader i’s problem, assuming possibly different discount factors βi :

∞ X
X
max βit ui [cti (s t )]πti (s t )
i
{bt+1 (s t )}
t=0 st
subject to
cti (s t ) + pt (s t )bt+1
i
(s t ) ≤ µt (s t )bti (s t−1 ) + yti (s t ) ≡ ati (s t )
Implicit assumption: natural debt limits, Euler eqs hold with equality.
FOCs yield the Euler equations:

i
(s t+1 |s t )µt+1 (s t+1 )[ct+1
i
(s t+1 )]−γi
P
t
βi s t+1 |s t πt+1
pt (s ) =
[cti (s t )]−γi
with γ1 = γ 6= 1 for consumer 1 and γ2 = 1 for consumer 2.
Recall that: ati (s t ) ≡ µt (s t )bti (s t−1 ) + yti (s t ).
For i = 2, given that u2 (c) = ln(c) and yt2 (s t ) = 0 for t > 0,
2 at2 (s t ) µt (s t )bt2 (s t−1 )

bt+1 (s t ) = β2 = β 2
pt (s t ) pt (s t )
a2 (s t )
“Proof”: guess-and-verify, vt (at2 (s t ), s t ) = ln (1−β
t
2)
+ v̂t (s t ), at the recursive
form ...



vt (at2 (s t ), s t ) = max ln [at2 (s t ) − pt (s t )bt+1
2
(s t )] +
2 t
bt+1 (s ) 
 | {z }
=ct (s t )



t+1 2 t

ln[µt+1 (s )bt+1 (s )]
X 2 
+ β2 πt+1 (s t+1 |s t ) + v̂t+1 (s t+1 )
1 − β2 
s t+1 |s t | {z }


2 t+1 t+1

=vt+1 (at+1 (s ),s )
2
Solve the FOC wrt bt+1 (s t ), substitute back, and verify.
For i = 2, given that u2 (c) = ln(c) and yt2 (s t ) = 0 for t > 0,
2 µt (s t )bt2 (s t−1 )
bt+1 (s t ) = β2
pt (s t )
2
Hence, by plugging optimal bt+1 (s t ) in the budget constraint.
ct2 (s t ) = at2 (s t ) − pt (s t )bt+1
2
(s t ) = (1 − β2 )µt (s t )bt2 (s t−1 )
Working out the Euler equation for i = 2 with γ2 = 1,

2
(s t+1 |s t )µt+1 (s t+1 )[ct+1
2
(s t+1 )]−1
P
β2 s t+1 |s t πt+1
pt (s t ) = 2 t −1
=
[ct (s )]
2
(s t+1 |s t )µt+1 (s t+1 )[(1 − β2 )µt+1 (s t+1 )bt+12
(s t )]−1
P
β2 s t+1 |s t πt+1
= 2 t −1
=
[ct (s )]
2
(s t )]−1 s t+1 |s t πt+1
2
(s t+1 |s t )
P
β2 [(1 − β2 )bt+1 β2 [(1 − β2 )bt+12
(s t )]−1
= 2 t −1
= 2 t −1
=
[ct (s )] [ct (s )]
β2 µt+1 (s̃ t+1 )[ct+1
2
(s̃ t+1 )]−1
= , for any s̃ t+1 |s t .
[ct2 (s t )]−1
Given s t , µt+1 (s̃ t+1 )[ct+1
2
(s̃ t+1 )]−1 is constant across all realizations of st+1 .
Equalize Euler equations to get rid off pt (s t ):
1
(s t+1 |s t )µt+1 (s t+1 )[ct+1
1
(s t+1 )]−γ
P
t
β1 s t+1 |s t πt+1
pt (s ) = =
[cti (s t )]−γ
β2 µt+1 (s̃ t+1 )[ct+1
2
(s̃ t+1 )]−1
= 2 , for any s̃ t+1 |s t .
[ct (s t )]−1
1
Rearranging terms, after multiplying and dividing by [ct+1 (s̃ t+1 )]−γ ,
1
[ct+1 (s̃ t+1 )]γ β1 1 1
[ct+1 (s̃ t )]γ
2 t+1
= 1 2 ,
ct+1 (s̃ ) β2 ξt+1 (s̃ ) ct+1 (s̃ t )
t+1
where ξti (s̃ t ) is an useful auxiliary variable: for s̃t |s t−1 ,
µt (s̃ t )[cti (s̃ t )]−γi

ξti (s̃ t ) = P i t t−1 )µ(s t )[c i (s t )]−γi
,
s t |s t−1 πt (s |s t
which has conditional mean one.

Define an auxiliary variable, useful to compute equilibrium: for s̃t |s t−1 ,
µt (s̃ t )[cti (s̃ t )]−γi
ξti (s̃ t ) = P i t t−1 )µ(s t )[c i (s t )]−γi
,
which has conditional mean one.
Note that since for i = 2, given s t−1 , µt (s t )[ct2 (s t )]−1 is constant for all
realizations of st , then for s̃ t |s t−1 ,
ξt2 (s̃ t ) = 1
Market clear condition implies that:

ct1 (s t ) = Yt (s t ) − ct2 (s t ) = Yt (s t ) − (1 − β2 )µt (s t )bt2 (s t−1 )
Hence, for agent i = 1 with γ1 = γ 6= 1, for s̃ t |s t−1 ,
µt (s̃ t )[Yt (s̃ t ) − (1 − β2 )µt (s̃ t )bt2 (s t−1 )]−γ
ξt1 (s̃ t ) = P 1 t t−1 )µ(s t )[Y (s t ) − (1 − β )µ (s t )b 2 (s t−1 )]−γ ,
s t |s t−1 πt (s |s t 2 t t
Specialization: perfect correlation between payoffs and aggregate
endowment, µt (s t ) = Yt (s t ).
µt (s̃ t )[Yt (s̃ t ) − (1 − β2 )µt (s̃ t )bt2 (s t−1 )]−γ
ξt1 (s̃ t ) = P 1 t t−1 )µ(s t )[Y (s t ) − (1 − β )µ (s t )b 2 (s t−1 )]−γ =
s t |s t−1 πt (s |s t 2 t t
[Yt (s̃ t )]1−γ [1 − (1 − β2 )bt2 (s t−1 )]−γ

= P 1 t t−1 )[Y (s t )]1−γ [1 − (1 − β )b 2 (s t−1 )]−γ
s t |s t−1 πt (s |s t 2 t
[Yt (s̃ t )]1−γ

= P 1 t t−1 )[Y (s t )]1−γ
More specializations:
I Yt (s t ) = Y (st ) follows i.i.d. process, πt (s t ) = π(st ) > 0 for st ∈ S;
I agents know st follows and i.i.d. process, but attach subjective
probabilities π i (st ) > 0, i = 1, 2.
Hence,
[Y (s̃t )]1−γ
ξt1 (s̃ t ) = ξ 1 (s̃t ) = P 1 1−γ
,
s∈S πt (s)[Y (s)]
which follows an i.i.d. process.
Summary so far, by manipulating Euler equations, we obtained,
1
[ct+1 (s̃ t+1 )]γ β1 1 [ct1 (s̃ t )]γ
2 = .
t+1
ct+1 (s̃ ) β2 ξt+1 (s̃ ) ct2 (s̃ t )
1 t+1
By imposing more structure (perfect correlation and i.i.d. shocks), we

obtained,
[Y (s̃t )]1−γ
ξt1 (s̃ t ) = ξ 1 (s̃t ) = P 1 1−γ
,
s∈S π (s)[Y (s)]
which follows and i.i.d. process.
Hence, by iterating the former equation backwards,

1 t+1
[ct+1 (s̃ t+1 )]γ β1 1 [c01 (s̃ 0 )]γ
2 (s̃ t+1 ) = t+1 1 .
ct+1 β2 c02 (s̃ 0 )
Q
j=1 ξ (s̃j )
1
Note that the evolution or consumption [ct+1 ]γ /ct+1
2
does not depend on
2
agent’s 2 beliefs, {π (s); s ∈ S}, who might have correct beliefs or not.
An example in which the agent with correct beliefs vanishes.
1 t+1
[ct+1 (s̃ t+1 )]γ β1 1 [c01 (s̃ 0 )]γ
2 (s̃ t+1 ) = t+1 1 ,
ct+1 β2 c02 (s̃ 0 )
Q
j=1 ξ (s̃j )
1
Note that the evolution or consumption [ct+1 ]γ /ct+1
2
does not depend on
agent’s 2 beliefs, {π 2 (s); s ∈ S}, who might have correct beliefs or not.
Qt+1
As long as j=1 ξ 1 (s̃j ) → 0 almost surely, given that aggregate
endowment is finite,
2
I if β2 = β1 , ct+1 (s̃ t+1 ) → 0 almost surely; i.e. i = 2 vanishes with
probability one even with correct beliefs;
I if β2 is marginally above β1 , by continuity, i = 2 vanishes even
being more patient and holding correct beliefs.
Qt+1
Next slide: j=1 ξ 1 (s̃j ) → 0 when {π 1 (s); s ∈ S} is inaccurate but
sufficiently close to {π(s); s ∈ S}.
Strike contrast with complete markets, in which the consumption of a

more patient consumer with more accurate beliefs cannot vanishes!
Qt+1
Want to show j=1 ξ 1 (s̃j ) → 0 almost surely when {π 1 (s); s ∈ S} is
inaccurate but sufficiently close to {π(s); s ∈ S}.
[Y (s̃t )]1−γ
Proof. Recall that: ξ 1 (s̃t ) = P
πt1 (s)[Y (s)]1−γ
; thus,
s∈S
T T
!
1 X 1 X X 1
ln ξ 1 (s̃j ) = ln [Y (s̃j )]1−γ − ln π (s)[Y (s)]1−γ
T j=1 T j=1
s∈S
In the limit, applying the LLN to the first term:

T
1 X X
lim ln [Y (s̃j )]1−γ = π(s) ln [Y (s)]1−γ
T →∞ T
j=1 s∈S
By Jensen’s inequality, there exists ε > 0, such that

T
!
1 X 1−γ
X 1−γ
lim ln [Y (s̃j )] − ln π(s)[Y (s)] < −ε
T →∞ T
j=1 s∈S
By continuity, given that {π 1 (s); s ∈ S} is sufficiently close to {π(s); s ∈ S},

T T
!
1 X 1 1 X 1−γ
X 1 1−γ
lim ln ξ (s̃j ) = lim ln [Y (s̃j )] −ln π (s)[Y (s)] < −ε
T →∞ T T →∞ T
j=1 j=1 s∈S
Hence, for T large enough, Tj=1 ξ 1 (s̃j ) < e −εT → 0, a.s.

Q
So far, an example in which the agent with correct beliefs vanishes.
Small twist to show that incomplete markets can be “beneficial”:

γ1 = γ2 = 1 such that ξt1 (s̃ t ) = ξt2 (s̃ t ) = 1; and β1 = β2 = β; thus,
1
ct+1 (s̃ t+1 ) c01 (s̃ 0 )
2 (s̃ t+1 ) = remains constant.
ct+1 c02 (s̃ 0 )
Incomplete markets allocation does not depend on beliefs; and equals the
one that would prevail in complete markets with correct beliefs.
I Not a general result when γ1 = γ2 = 1 and β1 = β2 = β.
I Recall that, within complete markets, consumption is a constant
fraction of aggregate endowment when utilities are CRRA.
I In the example, easy to show that agent two consumes a
fraction (1 − β), whereas agent one consumes a fraction β.
I Key ingredients in the example, aside γ = 1, to deliver this result:
I perfect correlation between payoffs and aggregate endowment;
I agent one holds the entire aggregate endowment after t = 1.
Last slide: one example showing that incomplete markets with potentially
incorrect (and heterogeneous) beliefs deliver the same allocation that
would prevail in complete markets with correct beliefs.
In that sense, incomplete markets can be “beneficial,” according to the

paternalistic view that welfare should be evaluated with true probabilities.
I Since utility is defined over actual consumption, so what matters are

the histories of consumption that will eventually be realized.
I Criticism against this paternalistic view. Agents might get hurt by

the subjective perception of being deprived of preferable options
that they would have chosen otherwise.
I An additional criticism in other normative analyses. Why does the

planner/government know the true beliefs while agents do not?
I Finance view (textbook approach). Reference: Campbell

(2018), Section 11.4.



Heterogeneous Beliefs: Finance View
Harrison and Kreps, 1978.
I Two ingredients: (i) restrictions on short sales; (ii) heterogeneous

beliefs.
I Miller, 1977. Asset prices above the level that would prevail if only
one of these conditions are present.
I Intuition: short sales prohibited, no additional supply of assets;

thus, prices equal the valuation of marginal optimistic buyer.
I In addition, let heterogeneous beliefs change over time, so that

different investors are more optimistic at different times.
I Harrison and Kreps, 1978. Asset prices can be above the

fundamental value perceived by any individual investor. Bubble!
I Intuition: option to resell the asset to someone more optimistic

when the asset holder becomes pessimistic.
Heterogeneous Beliefs: Finance View (Harrison-Kreps)
Example in Harrison and Kreps, 1978.
I Discrete-state Markov process with two states, st ∈ {L, H}.
I A risky asset pays dt = 0 in state L and dt = 1 in state H.
I Two agents who differ in their beliefs about transition probabilities,

i i

i πLL 1 − πLL
P = i i .
1 − πHH πHH
I Both agents are risk neutral with common discount factor δ. Hence,
∞ ∞
X X 0 0
Fti = Eti δ j dt+j = (δP i )j = δP i (I − δP i )−1 .
1 1
j=1 j=1
Symmetric example: for φ ∈ [1/2, 1),

1 φ 1−φ 2 1−φ φ
P = and P = ,
1−φ φ φ 1−φ
so that agent i = 1 becomes relatively more pessimistic (optimistic)
when state L (state H) realizes.
Hence,
δ 1 − φδ
F1 = .
(1 − δ)(1 + δ − 2δφ) φ + δ − 2δφ
Asset prices with short-sales constraint: at state L and H,

pL = δ max{φpL + (1 − φ)(1 + pH ), (1 − φ)pL + φ(1 + pH )}
pH = δ max{(1 − φ)pL + φ(1 + pH ), φpL + (1 − φ)(1 + pH )}
Symmetry implies that pL = pH . Since φ ≥ 1/2,

δφ
p = δ max{p + φ, p + (1 − φ)} = δ(p + φ) ⇒ p =
1−δ
Valuation of agent i = 1 over price:

F1

1 1 − φδ 1 1
= < ⇐⇒ φ>
p φ(1 + δ − 2δφ) φ + δ − 2δφ 1 2
In this example, whenever there is disagreement, price is always above

agents’ perceived fundamental values.
Why do agents hold the asset despite the fact that they perceive
overvaluation?
Intuition: “[...] each agent believes he benefits from the existence of the
other agent who he believes to have incorrect beliefs. The option to resell
the asset to a counterparty with different beliefs, in a state where the
counterparty is more optimistic, is valuable and increases the price at
which each agent is willing to hold the asset.”
Comments: overpricing, overvaluation, bubble.
I Overpricing is greater when interest rates are low, i.e. δ ↑. Intuition:

option to resell more valuable in present value.
I Scheinkman and Xiong (2003) derive testable implications.

Overvaluation is ...
I ... positively correlated with market prices, volatility and

trading volume (i.e., frenzied trading).
I ... negatively correlated with free float (available quantity of
shares) – binding short-sales constraints when free float is low.
I Puzzle: volatile individual stocks have surprisingly low average

returns. Harrison-Kreps and Scheinkman-Xiong can explain it.
I High volatility could be a signal of disagreement, which in turn

corresponds to greater overpricing.
Heterogeneous Beliefs: Finance View
Geanakoplos, 2003, 2010.
I Simple “static” model of the determination of leverage (or margins).
I New ingredient (aside heterogeneous beliefs and short-selling

constraint): noncontigent nonrecourse collaterized borrowing.
I Nonrecourse: lender can seize only the collateral and nothing else.
I Basic setup: risk-neutral investors with different beliefs indexed by

h ∈ (0, 1), concerning the probability of two states (H and L).
I A risky asset generates one unit of consumption in the state H, and

d < 1 units in the stat L. Assume that πHh = h and πLh = 1 − h.
I Each agents initially hold one unit of the asset and one unit of the
consumption good. Prices adjust to clear the market.
I Three cases: no borrowing; riskfree borrowing; and risky borrowing.

Heterogeneous Beliefs: Finance View (Geanakoplos)
Case one: no borrowing.
Risk-neutrality + static model: asset price = marginal buyer’s payoff.
p = b + (1 − b)d,
where h = b is the marginal buyer.
Net supply of shares = net demand for shares.

1−b 1−b
b= ⇐⇒ p=
p b
Example: if d = 0.2, b ∗ = 0.6 and p ∗ = 0.68.

Case two: riskfree borrowing.
Two periods: t = 0, borrowing/lending; t = 1, “static model”.

Assumption: zero pure rate of time preference (δ = 1).
Loan has two elements: (i) amount it promises to pay, say φ; (ii)
collateral that backs up that promise.
Since δ = 1, the amount that can be borrowed today is φ.
Collateral is one share of the risky asset. Hence, payment the loan
makes: (i) min(φ, 1) in state H and min(φ, d) in state L.
Assumption: exogenous constraint, φ ≤ d, which makes the debt riskfree.
Optimists use their shares to borrow as most as they can. Market clear:
1−b+d 1−b+d
b= ⇐⇒ p=
p b
In equilibrium: fewer, more optimistic investors. If d = 0.2,∗ b ∗ = 0.69,
p∗
p = 0.75. Leverage: p∗ −d = 1.36; margin requirement: p p−d
∗
∗ = 0.73.
Case three: risky borrowing.
In principle, φ > d, which makes the debt risky.
Let π(φ) be the amount that can be borrowed. If φ > d, then r (φ) > 0
must compensate for the risk of default.
φ
1 + r (φ) =
π(φ)
Note that: π(φ) = bφ + (1 − b)d.
Spoiler: although risky borrowing can be used to increase leverage, it

does not occur in equilibrium (see Geanakoplos). Not a general result!
Intuition: risky loans shift payments from state L to state H. From the
point of view of borrowers (optimists), who think state H is more likely,
this shift in payments is not attractively priced.
Although it does not occur in equilibrium, one can price risky debt. If
d = 0.2 < φ = 0.3: b ∗ = 0.69 (as before), π(0.3) = 0.27, r (0.3) = 12%.
Geanakoplos (2003, 2010): two states, continuum of agents.
Simsek (2013): continuum of states, two agents (O and P).
Simsek shows that: (i) risky borrowing can occur; (ii) nature of
disagreement becomes important.
Intuition with three states: good H, neutral N and bad L.

I If O and P disagree about the prob of L, risky borrowing does not
occur. Same intuition: price of risky asset closer to P’s valuation.
I But if O and P agree with the probability of L, when default
happens, risky borrowing can occur. Price closer to O’s valuation.
Let v̄ is the threshold level of the collaterized asset’s future value such
that risky loan default for any v < v̄ . Key equation in Simsek:
Price = πP [v < v̄ ]EP [v |v < v̄ ] + πP [v ≥ v̄ ]EO [v |v ≥ v̄ ]
In words: optimistic beliefs about good states have a greater effect upon
asset prices than optimistic beliefs about bad states.
Generating a crash (or the leverage cycle).
Special shock: “scary” bad news. It not only lowers expectations but
creates more uncertainty (and, thus, more disagreement).
Idea: ultimate failure requires too many things to go wrong to be of large

probability. Once things go wrong, uncertainty (disagreement) goes up.
Example: output is one unless two iid events go wrong, otherwise output
is 0.2. Optimistic (pessimistic) believes each occurs with prob 0.1 (0.2).
optimistic pessimistic
prob breakdown 0.01 0.04
expected output 0.992 0.968
variance output 0.0063 0.025
expected output | bad news 0.92 0.84
variance output | bad news 0.058 0.102
Special shock: “scary” bad news. It not only lowers expectations but
creates more uncertainty (and, thus, more disagreement).
Two-period event three: risky asset pays one in the states HH, HL and
LH, but only pays 0.2 in state LL.
Solution (see Geanakoplos):
Crash: the decline from 0.95 to 0.69 (i.e., 0.26) is larger than the decline
in perceived fundamental value for any h.
max[(h2 + 2h(1 − h) + (1 − h)2 0.2) − (h + (1 − h)0.2)] = 0.20
h
Crash: the decline from 0.95 to 0.69 (i.e., 0.26) is larger than the decline
in perceived fundamental value for any h.
Intuition (two forces): the leverage cycle.
1. price decline transfers wealth from leveraged optimistic borrowers to

pessimistic lenders;
2. equilibrium leverage falls form 0.95/(0.95 - 0.69) = 3.6 to

0.69/(0.69 - 0.2) = 1.4.
In this example, a “scary” bad news increased uncertainty and thus

disagreement between optimist-borrowers and pessimist-creditors.

Section 11.4.



Heterogeneous Beliefs: Few Insights
Insight one: lot of disagreement in the data (they move together among
professional forecasters, economists and the general public).
Example from Mankiw, Reis and Wolfers (2004): inflation expectations.
Interquartile range: difference between 75th and 25th percentiles.

Insight two: disagreement spillovers to the real economy.
VAR evidence from Gilchrist, Himmelberg and Huberman (2005):

investment increases with dispersion in stock analysts’ earning forecasts.
Rationale: (i) cheap source of capital (Gilchrist et al, 2005); (ii) optimal
executive compensation and short-termist behavior (Bolton et al, 2006).
Insight three (Scheinkman and Xiong, 2003): significant bubble

component even with small differences in beliefs; no need for outrageous
amount of optimism.
Insight four: bubbles tend to coincide with technological and financial

innovations, since they arrive with great fundamental uncertainty.
Insight five: some bubbles burst coincides with increases in asset’s

supply; intuitively, two effects: (i) easy short-sale constraints; (ii) change
the marginal buyer, who is less optimistic.
Insight six: why differences in beliefs arise and persist?

I Overconfidence: tendency of individuals to exaggerate the precision
of their knowledge.
I Example: Ben-David et al, 2013. Quarterly survey of senior
finance executives (approx. 12500 observations).
I Elicit an 10-90 interval the respondent believe that S&P return
over next year would fall within.
I Realized returns fell within intervals only 36% of the time.
I What about learning? It takes longer to learn than bubbles last.
I What about natural selection (i.e., those who lose wealth on
average have a vanishing influence on market outcomes)?
I Depends on market structure, preferences; even if true,
simulations suggest it may take hundreds of years.
I Origins of optimism: advice from “experts” who are overly
optimistic about new technologies.
Insight seven: empirical evidence on the key mechanism of the model
(costly short-selling + dispersion of beliefs ⇒ “bubble”).
Diether et al (2002): sort stocks according according to the dispersion in
analysts’ forecasts as proxy for difference in opinions.
In line with the theory, dispersion is associated with lower returns (higher
prices), especially for smaller stocks (those that are harder to short-sell).
Inconsistent with the view that dispersion in forecasts proxies for risk.
Side note. Smaller stocks in terms of market capitalization, i.e. total
dollar market value of a company’s outstanding shares.
More evidence: D’avolio (2002), Mei et al (2009), Xiong and Ju (2011).
Insight eight: welfare analysis with distorted beliefs.

I In the presence of distorted beliefs, paternalistic view argues for the
use of objective probabilities that drives uncertainty.
I But if such objective probabilities are not observable, whose beliefs
should the social planner use to analyze social welfare?
I Brunnermeier, Simsek and Xiong (2014), belief-neutral welfare
criterion:
I “If social allocation is inefficient under any reasonable
probability measure (i.e., any convex combination of all agents’
beliefs), then it is belief-neutral inefficient.”
I Of course, this criterion is highly restrictive: it requires consistent
ranking of allocations under a large set of probability measures.
I Nonetheless, this criterion is useful in detecting negative-sum games
the agents might play due to heterogeneous beliefs.
Insight eight: welfare analysis with distorted beliefs. Example:
I Two states (H and L), two agents (A and B) with u such that
u 0 > 0 and u 00 < 0. Assume that π A > π B (subjective prob of H).
I Agents endowed with 0.5 units of the good in every state. They can
trade k contracts at price p that pay a unity of the good at H.
I For some λ ∈ [0, 1], let π = λπ A + (1 − λ)π B . Utilitarian social
welfare criterion with equal weights:
π[u(0.5+k(1−p))+u(0.5−k(1−p))]+(1−π)[u(0.5−kp)+u(0.5+kp)],
which is maximized at k = 0 due to u 00 < 0 for all λ ∈ [0, 1].

I Hence, this welfare criterion selects status quo (no trade), although
some trade occurs in equilibrium due to heterogeneous beliefs.
I Intuitively, speculative trading makes consumption more volatile,
reducing expected utilities (negative-sum game in expected utilities).
I Introducing trading costs when agents are risk-neutral makes
Harrison-Kreps (and subsequent papers) a negative-sum game.
Insight nine: other theories of bubble.

1. Rational bubbles in the context of overlapping generation models
(e.g., Tirole, 1985) . Problems:
I bubbles are not associated with high trading volume;
I the asset must be infinitely lived, whose price grows without
bounds; bubbles cannot arise in assets with finite maturities.
2. Behavioral bubbles: Shiller (2005)’s feedback loop of bubbles.
I Behavioral bias engenders feedback to past returns, amplifying
some precipitating factor (e.g., overexcitement).
3. Bubbles arising from agency problems (asymmetric information and
contracting frictions).
I Allen and Gorton (1993): portfolio managers bear limited
downside risk (get fired); seek risk at the expense of investors.
I Allen and Gale (2010): investors-borrowers bear limited
downside risk (default); seek risk at the expense of lenders.

Section 11.4.

I Detour. Diagnostic expectations: Gennaioli and Shleifer

(2018), parts of Chapters 4, 5 and 6.

Detour: Diagnostic Expectations
Rational Expectations Hypothesis: beliefs (i.e., forecast of the future) are

formed using the structure of the economy agents operate in.
I Among the most important advances in economics.
I It brought elegance, discipline and powerful empirical content to

models on business cycle and financial markets.
I REH unified microeconomic theory with macroeconomic models.
I The assumption that the economic model and expectations are

consistent, by eliminating all free parameters to set beliefs, delivered
a lot of structure and predictive power.
I No need to measure expectations directly, or set beliefs ad-hoc.

Survey data on expectations are redundant and not necessary.
In addition, skepticism about quality of survey expectations data.
I Respondents might not understand the question.
I Big leap from “What do you expect?” in a survey to “What is
your true-measure conditional mean?” in a model.
I Survey never asks: “By the way, did you report your
risk-neutral or true-measure mean?”
I What if people are reporting the former?
I The colloquial word “expect” is centuries older than the
mathematical concept of true-measure conditional mean.
I Lack of incentives to answer them accurately. Agents may act “as
if” rational (no matter how surveys are filled out).
I “Much animal behavior is well described by optimization—how
bees search flowers for pollen, for example—yet they do not
answer surveys coherently either.” (Cochrane, 2017).
I Phelps (1977): “Like utility, expectations are not observed, and
surveys cannot be used to test the rational expectations hypothesis.”
Shleifer and co-authors, Manski, among others, challenge this skepticism

regarding the use of survey expectations data.
I Almost all economic data come from surveys, and are subject to the
same criticisms (e.g., lack of incentives to respond accurately).
I Phelps’ analogy to utility not valid. For consumers, harder to come
up with a quantitative measure of their tastes than a probability
distribution on the eventual realization of some events.
Objectives in this lecture:

I Some empirical evidence suggesting expectations data do not reflect
only measurement error, and are inconsistent with the REH.
I Propose a parsimonious alternative to RE that keeps tractability.
Namely, Diagnostic Expectations due to Shleifer and co-authors.
Review: Asset Pricing with Rational Expectations
Focus: leading example in macro-finance, asset pricing.
Benchmark: asset pricing with complete markets and rational

expectations. Ljungqvist and Sargent, ch 8. Transactions in time-0.
Time-0 agent’s i problem, given a system of prices {qt0 (s t )},

∞ X
X
max β t u(cti (s t ))πt (s t ),
{{cti (s t )}s t }∞
t=0 t=0 s t
subject to the time-0 budget constraint,

∞ X
X ∞ X
X
qt0 (s t )cti (s t ) ≤ qt0 (s t )yti (s t ).
t=0 st t=0 st
Lagrangian,
∞ X
X ∞ X
X
L= β t u(cti (s t ))πt (s t ) + µi qt0 (s t )(yti (s t ) − cti (s t )),
t=0 s t t=0 s t
where µi is the multiplier associated with the budget constraint.

FOC wrt cti (s t ):
β t u 0 [cti (s t )]πt (s t )
qt0 (s t ) = >0
µi
I subscript t means the good that will be delivered in t;

I superscript 0 means the price of the good to be delivered in t is
measured in terms of consumption unities at time-0;
I complete markets: such price exists for all t, s t .
To get the price of the good to be delivered in t measured in terms of

consumption unities at τ ,
qt0 (s t ) β t u 0 [c i (s t )]πt (s t ) u 0 [c i (s t )]
qtτ (s t ) ≡ 0 τ
= τ 0 it τ τ
= β t−τ 0 it τ πt (s t |s τ )
qτ (s ) β u [cτ (s )]πτ (s ) u [cτ (s )]
Prices of a one-period ahead asset, i.e. t = τ + 1,
u 0 [cτi +1 (s τ +1 )]
qττ +1 (s τ +1 ) = β πτ +1 (s τ +1 |s τ )
u 0 [cτi (s τ )]
Assume a one-period asset that generates a random payoff ω(sτ +1 ),
0
X u (cτ +1 )
pττ (s τ ) = qττ +1 (s τ +1 )ω(sτ +1 ) = Eτ β 0 ω(sτ +1 ) .
τ +1
u (cτ )
s
Return of this asset: Rτ +1 ≡ ω(sτ +1 )/pττ (s τ ). Euler equation:

0
u (cτ +1 )
1 = Eτ β 0 Rτ +1 ≡ Eτ [mτ +1 Rτ +1 ] ,
u (cτ )
0
where mτ +1 ≡ β uu(c τ +1 )
0 (c )
τ
is the stochastic discount factor.
Law if iterated expectations:

0
u (cτ +1 )
1=E β 0 Rτ +1 ≡ E [mτ +1 Rτ +1 ] .
u (cτ )
0
Stochastic discount factor: mτ +1 ≡ β uu(c τ +1 )
0 (c ) .
τ
Euler equation (valid for all one-period ahead assets):

E [mτ +1 Rτ +1 ] = 1
Example 1: U.S. risk-free bond Rτb+1 ≈ 1.01 (annual avg 1889-1978)

E mτ +1 Rτb+1 = 1

Example 2: Standard & Poor’s 500 index Rτs +1 ≈ 1.07 (annual avg
1889-1978)
E mτ +1 Rτs +1 = 1

Combining both:
E mτ +1 (Rτs +1 − Rτb+1 ) = 0

Finally,
0 = E mτ +1 (Rτs +1 − Rτb+1 ) = E [mτ +1 ] E Rτs +1 − Rτb+1 +

+ cov mτ +1 , Rτs +1 − Rτb+1

Hence,
s b
s b cov(mt+1 , Rt+1 − Rt+1 ) u 0 (ct+1 )
E [Rt+1 − Rt+1 ]=− , where mt+1 = β 0 .
E [mt+1 ] u (ct )
Theory: an average/expected positive equity premium requires a negative

s b
covariance between SDF, mt+1 , and excess returns, Rt+1 − Rt+1 .
Empirical evidence: estimative of the equity premium of nearly 4%-8%.
Why individuals do not demand more stock shares? RE theory: fear of

s b
consumption drop! ct+1 ↓; thus, mt+1 ↑, Rt+1 − Rt+1 ↓.
I Risky assets (bad insurance instrument): returns fall (increase) at
bad (good) states, when consumption also falls (increases).
I Note that, according to the model, conditional on bad (good)
states, expected returns increase (decrease).
Equity premium puzzle: for reasonable parametrizations of u, empirical

SDF not sufficiently volatile to make model match the size of premium.
Non-exhaustive list of theories trying to the fix puzzle within the RE
framework, i.e. even more fear of a consumption drop at bad states.
1. Recursive utility (Epstein e Zin, 1989)
2. Long-run risk (Bansal e Yaron, 2004; Bansal et al, 2012)
3. Rare disasters (Reitz, 1988; Barro, 2006)
4. Idiosyncratic risk (Constantinides e Duffie, 1996)
5. Habits (Campbell e Cochrane, 1999a, 1999b)
6. Non-separable u between goods (Piazzesi, Schneider e Tuzel, 2007)
7. Heterogeneous preferences (Gârleanu e Panageas, 2015)
8. Financial frictions (Guvenen, 2009; Krishnamurthy e He, 2013)
9. Ambiguity aversion, min-max preferences (Hansen e Sargent, 2001)
All of them are “rational” and generalize the stochastic discount factor:
u 0 (ct+1 )
mt+1 = β yt+1 , where yt+1 does the job.
u 0 (ct )
See Cochrane (2017).
Behavioral Approach
Another approach to explain the puzzle: behavioral; probability errors
(Shiller, 1984, 2014).
Basic asset pricing equation,

−γ
X ct+1,s
1 = Ẽ (mt+1 Rt+1 ) = π̃s β Rt+1,s ,
s
ct
where s is the state, and π̃s is the subjective probability s will realize.
Idea: instead of explaining asset pricing through SDF, this approach

introduces beliefs’ distortions (or probability errors).
For example, subjective beliefs are π̃s = πs yt+1 , where is yt+1 is a

sentiment shock, which is equivalent to make the SDF more volatile.
Next slides: a closer look at π̃s “regarding” aggregate stock returns,

proxying it with survey expectations data.
Empirical evidence on expectations of aggregate stock returns over the

next year from six surveys (Greenwood and Shleifer, 2014).
Not noise!?: expectation measures not only correlate among themselves,

but also with actual behavior (last row, flows into stock market).
next year (Greenwood and Shleifer, 2014).
Not noise!?: expectation measures correlate with actual behavior (flows

into stock market, i.e. equity mutual funds).
next year (Gennaioli, Ma and Shleifer, 2015).
Extrapolative behavior: past realized returns feed into the expectation

of future returns.
In addition, run the regression with monthly data,
s
Rt,t+12 = a + bXt + ut ,
where Xt is a measure of expectations of aggregate stock returns over

the next year.
Rational expectations: b = 1, which is rejected by the data. Greenwood

and Shleifer’s estimation: b < 0.
In words, high returns that feed into expectations, are associated with
average lower returns going forward.
Conclusion. If expectation survey data are not only noise, they are in
sharp contrast with expectations implied by RE theories of asset pricing.
I In the data, forecasting errors: when past returns are high, expected
future returns are on average higher than realizations.
I RE theory: conditional on good states (say booms), when returns
are high, expected returns are low; opposite holds for bad states.
So far, some empirical evidence suggesting expectations data do not
reflect only measurement error, and are inconsistent with the REH.
Next: propose a parsimonious alternative to RE that keeps tractability.

Namely, Diagnostic Expectations due to Shleifer and co-authors.
“The survival of the customized approach to modeling (behavioral) biases may

be due in part to a resistance to unification. Behavioral economics developed
originally as a collection of tests and rejections of the predictions of neoclassical
theory, whose point of pride is precisely a unified approach to human behavior.
Unification was not the point of these daring and effective hit-and-run attacks
on the colossus.”
21st century battle for macroeconomics to make progress!?

I What is a reasonable “unified” and “tractable” alternative approach
to benchmark RE that can be “massified”?
I Woodford (several approaches), Sims (rational inattention),
Angeletos (lack of common knowledge), Shleifer (diag expec), etc.
Behavorial economics. Kahneman and Tversky (1974):

I Heuristics are “rules of thumb”, humans use to speed up cognition.
I May have emerged from an adaptive process. They often yield good
approximate answers, but also some mistakes every now and then.
I Humans use a few heuristics: representativeness, availability, and
anchoring.
I Availability: evaluations/decisions based on immediate
examples that come to a given person’s mind.
I Anchoring: evaluations/decisions rely too heavily on an initial
piece of information.
I Diagnostic expectations based on representativeness heuristic, used
to make judgments about the prob of an event under uncertainty.
I It captures our tendency to judge likelihood by similarity.
I But likelihood and similarity do not always go together.
Examples: black swan, neglected risk.
Kahneman and Tversky (1983): “An attribute is representative of a class
if it is very diagnostic, that is, if the relative frequency of this attribute is
much higher in that class than in a relevant reference class.”
It is a relative (rather than an absolute) likelihood concept, which is

easier to formalize in a standard probabilistic model.
Suppose a decision maker aims to assess the distribution of types

(attributes) T in a given group (class) G . Let −G be the comparison
group (relevant reference class).
The true distribution of types in G and −G follows a conditional

probabilities, h(T = τ |G ) and h(T = τ | − G ), respectively
Define representativeness of a type T = τ as:

h(T = τ |G )
R(τ, G ) ≡
h(T = τ | − G )
Diagnostic expectations (or beliefs), for θ ≥ 0,
θ
h(T = τ |G )
h(T = τ |G ) Z,
h(T = τ | − G )
where Z is a constant to guarantee that the distorted density above
integrates to one.
In words, beliefs are distorted by attributing more probability towards

types that are more diagnostic in (i.e., representative of) a group.
Clarification example: G is Irish people; −G the rest of the world, and T

is hair color. True distribution:
Red Light/Brown Dark
Irish 10% 40% 50%
World 1% 14% 85%
R(τ, G ) 10 2.9 0.6
Red hair is very diagnostic. Despite dark-haired people being majority
among the Irish, people tend to report large incidence of red hair.
Comments:
I Parsimonious model of beliefs: if θ = 0, back to RE.
I “Biological-foundation”: oversample of representative types from
limited and selective memory (see explanation in the book).
I Accounts for many behavioral biases, e.g. conjunction fallacy and
base rate neglect (see explanation in the book).
I “Portable” across domains, explaining different phenomena, from
stereotypes (exaggeration of real differences) to credit cycles.
I “Kernel of truth principle”, but exaggeration, overreaction to news.
I Forward-looking, rather than mechanical extrapolative beliefs. Not
subject to the Lucas critique, e.g. beliefs change with policy.
I An attempt towards a rigorous unified micro-founded approach,
with well-established features of human memory and judgment.
I But what about other heuristics/behavioral biases/biological
processes (e.g. anchoring/underreaction/attention)?
I Key difference to RE: starting point is biology rather than rationality.
Another clarifying example.
Information arriving about some future cash flow X̃ (e.g., payoff on

mortgages, stock market returns, ...).
T is the cash flow; G is current information at t = 0, and −G is

information at t = −1. Hence, diagnostic expectations: for some θ > 0,
" #θ
f (X̃ |I0 )
f (X̃ |I0 ) Z.
f (X̃ |I−1 )
Suppose that ln X̃ |I0 ∼ N(µ0 , σ02 ) and ln X̃ |I−1 ∼ N(µ−1 , σ−1

2
).
Information flow: µ0 6= µ−1 and/or σ0 6= σ−1 .
Resulting beliefs regarding X̃ is also log-normal, with

2
θσ02 2 2 σ−1
µ0 (θ) = µ0 + 2 + θ(σ 2 − σ 2 ) (µ0 −µ−1 ) and σ 0 (θ) = σ 0 + 2 + θ(σ 2 − σ 2 )
σ−1 −1 0 σ−1 −1 0
Kernel of truth (overweight economic outcomes that become more likely):

if good news, µ0 > µ−1 (σ0 < σ−1 ), then µ0 (θ) > µ0 (σ0 (θ) < σ0 ).
Gennaiolli and Shleifer’s book: diagnostic beliefs were a crucial ingredient
to understand the Great Recession.
I Mortgages/house prices (µ0 > µ−1 ) implied neglected downside risk;
I Securitization (σ0 < σ−1 ) increased the perception of cash flow
safety.
Gennaiolli and Shleifer’s book: diagnostic beliefs are crucial to

understand the crisis.
I Mortgages/house prices (µ0 > µ−1 ) implied neglected downside risk;
I Securitization (σ0 < σ−1 ) increased the perception of cash flow
safety.
Recall: regarding expectations of aggregate stock returns,
I Extrapolative behavior: past realized returns feed into the
expectation of future returns.
I Forecasting errors: when past returns are high (low), expected
future returns are on average higher (lower) than realizations.
Next: show that diagnostic expectations account for these patterns.
Suppose the decision maker is forecasting a variable X̂t+1 that follows an
AR(1) process, X̂t+1 = ρX̂t + εt+1 , with εt+1 ∼ N(0, σ 2 )
I T is the future realization X̂t+1 ; G is the current state X̂t ;
I and −G are “past conditions” ρX̂t−1 (state that would occur today
in the absence of news).
Diagnostic expectations:
" #θ
f (X̂t+1 |X̂t )
f (X̂t+1 |X̂t ) Z.
f (X̂t+1 |ρX̂t−1 )
Intuition: the most representative future states X̂t+1 are those whose true
likelihood has increased the most on the basis of recent news.
" #θ
f (X̂t+1 |X̂t )
f (X̂t+1 |X̂t ) Z.
f (X̂t+1 |ρX̂t−1 )
Suppose X̂t is the current value of the stock market index.
Rational expectations: Et (X̂t+1 ) = ρX̂t .
Diagnostic expectations. It is possible to show that:
Etθ (X̂t+1 ) = ρX̂t + ρθ(X̂t − ρX̂t−1 )
If ρ > 0, distortion of rational expectation, ρX̂t , in the direction of

current news (X̂t − ρX̂t−1 ), which is positive (negative) if good (bad).
I Extrapolation. Etθ (X̂t+1 ) − ρX̂t = ρθ(X̂t − ρX̂t−1 ).
I After good (bad) news, i.e. realizations on the right (left) tail,
expectations are too optimistic (pessimistic). Overreaction to info.
Suppose X̂t is the current value of the stock market index.
Under rational expectations, cov(X̂t+1 − Et (X̂t+1 ), X̂t ) = 0.
It is also possible to compute: if ρ > 0,

cov(X̂t+1 − Etθ (X̂t+1 ), X̂t ) = −θρσ 2 < 0.
High (low) X̂t associated with good (bad) past news; overreaction creates
excess optimism (pessimism) and negative (positive) forecast errors.
Diagnostic expectations are in line with both features of the data.
Another property. Diagnostic expectations generate systematic reversal

of expectations errors, i.e. they disappear in the future,
θ
Et [Et+1 (X̂t+2 )] = Et [X̂t+2 ] = ρ2 X̂t .
Intuitively, exprapolation emerges from overreaction to news, but on
average no news in the future, so expectations revert to rationality.
Recent macro empirics: substantial evidence connecting expansion of
credit to future financial crises and recessions (credit cycles).
I Schularick and Taylor (2012, panel countries): established link
between past credit booms and higher probability of financial crisis.
I Baron and Xiong (2017, panel countries): role of risky debt;
established link between past bank credit expansions and higher
probability of a crash and low average returns on bank stocks.
I Greenwood and Hansen (2013, US data):
I credit spreads (cost of risky minus safe debt) and share of risky
debt issuance are barometers of credit market sentiment;
I i.e. optimism about returns on risky assets drives credit
spreads down and risky debt issuance up;
I low credit spreads and high debt issuance predict low returns
on risky debt going forward.
I López-Salido, Stein and Zakrajsek (2017): low credit spreads and
high debt issuance predict (optimism) also predict recessions.
I Kirti (2018) confirms this finding in a panel of countries.
Recent macro empirics (continuation).
I Mian and Sufi (2009, 2014): expansion of mortgage debt played a
central role for the financial crisis and the Great Recession.
I Mian, Sufi and Verner (2017): household debt is more important
than corporate or bank debt for predicting recession.
I Mechanism: household debt overhang detrimental to consump.
I Jordà, Schularick and Taylor (2015): growth of mortgage debt is a
successful predictor of crises.
All this evidence appears to fit together: credit expansions, particularly of
risky credit, increase financial fragility and the chances of a recession.
Book provides a highly stylized and standard macro model, except that
expectations are diagnostic, that can generate such credit cycles.
I Driving force: good news on TFP of firms that issue debt to invest.
I Diagnostic expectations not only imply more risky debt issuance and
lower credit spreads and, thus, more investment and production;
I but also the opposite looking forward due to reversion of expectation
errors. Result: initial optimism ⇒ default on debt and recession.
An attempt to translate diagnostic expectations when shocks follow a
discrete Markov chain, with S states and transition probabilities πs,s 0 .
Target T is the future realization of the state, s 0 ; the group G is the
current realization of the state, s.
What about −G ? Three possibilities. As in the stereotype example, all
other states rather than s, thus
!θ
πs,s 0
π̃s,s 0 = πs,s 0 P Zs .
k6=s πk,s
0
Or, as in the flow of info example, −G is described by past conditions,

θ
πs,s 0
π̃s,s 0 (s−1 ) = πs,s 0 P Zs .
k πs−1 ,k πk,s
0
Or, alternatively, to avoid an extra state variable, −G could be described

by even paster conditions,
θ
πs,s 0
π̃s,s 0 = πs,s 0 P Zs .
k π̄k πk,s
0
where {π̄s } is the invariant distribution associated with {πs,s 0 }.

Final comment. Suppose two states: s ∈ {L, H}.
In all cases above, a simple algebra shows that π̃L,L > πL,L and
π̃H,H > πH,H , if and only if
πL,L πH,H > (1 − πL,L )(1 − πH,H ),
i.e. shocks are persistent.
Let state H (state L) be boom (recession), Hamilton (1989) estimated

πHH = 0.9 and πLL = 0.75 with quarterly US GDP growth data.
Hence, agents who hold diagnostic expectations believe that booms and
recessions endure more than they really do.
They are optimists (pessimists) during booms (recessions).


Section 11.4.


I Shameless self-promotion: “Speculation-Driven Business

Cycles”, Bigio and Zilberman (2020).
But before ...
Figure in Brunnermeier and Sannikov (2018), chapter in the Handbook of
Macroeconomics.
Advantadge of continuous-time: tractability!

But before ...
Caballero and Simsek (forthcoming). A Risk-centric Model of Demand
Recessions and Speculation.
Two period model, t ∈ {0, 1}, to illustrate the mechanism.
I Single consumption good. Single factor of production, capital which
is fixed and normalized to one.
I Potential output = capital’s productivity
zt , with z0 = 1 and z1
σ2 2
uncertain with distribution log z1 ∼ N g − 2 , σ .
I g captures the (log) expected growth rate of productivity.
I Actual output, yt ≤ zt , which can be below potential output due to

a shortage of aggregate demand.
I Assume y1 = z1 . Focus on endog. determination of y0 ≤ z0 .
I Menu of financial assets:

I Risk-free asset in zero net supply with log return r f .
I Mkt portfolio: payoff z1 , price Q; log return r m (z1 ) = log z1
Q.
Caballero and Simsek (forthcoming)
Demand side. Start with a representative investor endowed with
y0 + Q (output + market portfolio), with discount factor e −ρ .
Investor chooses consumption, shares (1 − ω m ) of riskfree asset and ω m
of risky asset holdings. Epstein-Zin preferences with EIS = 1:
1
c0 = (y0 + Q) .
1 + e −ρ
Risk balance condition:
σ2
1 E [r m (z1 )] + − rf 1 g − log Q − r f
ωm σ ≈ 2
⇒ σ≈ .
γ σ γ| σ
{z }
Sharpe ratio
Supply side. Nominal prices are fixed. Available demand at these prices
are met as long as prices are higher than marginal cost. Market clear:
c0 = y0 ≤ z0 = 1.
Monetary policy. Aim is to replicate y0 = 1 (full capacity), subject to

the zero lower bound,
r f = max(0, r f ∗ ), where r f ∗ is the natural interest rate.
Combining c0 = y0 and
1
c0 = (y0 + Q) ⇒ y0 = e ρ Q,
1 + e −ρ
which is the output-asset price relation.
Finding r f ∗ , i.e. r f such that y0 = z0 = 1 and, thus, log Q = −ρ. Hence,
1 g − log Q − r f
σ= ⇒ r f ∗ = g + ρ − γσ 2 .
γ σ
As long as r f ∗ > 0, monetary policy r f = r f ∗ ensures full capacity.
Now consider a risk premium shock, γ ↑ and/or σ 2 ↑, such that r f ∗ < 0

and thus r f = 0. We have a demand recession:
1 g − log Q − r f
σ= ⇒ log Q = g − γσ 2 < −ρ ⇒ y0 < 1.
γ σ
Also, note, that a surge in pessimism (decline in expected growth), g ↓,
decreases asset prices and worsens the recession.
Finally, assume now two investors, (o)ptimist and (p)essimist, and
heterogeneous beliefs regarding g : g o > g p (expected growth rate).
Following similar steps, one can show that:
r f ∗ ≈ αg 0 + (1 − α)g p + ρ − γσ 2 ,
where α is the optimist’s wealth share, i.e. share α ∈ (0, 1) of (y0 + Q).
If after a risk premium shock, γσ 2 ↑, r f ∗ < 0:
log Q ≈ αg o + (1 − α)g p − γσ 2 < ρ.
Reduction in optimist’s wealth share, α, exacerbates the recession.
Caballero and Simsek embed this mechanism in a tractable continuous

time model, and α becomes endogenous to heterogeneous beliefs.
I In a recession phase, wealthier optimists would help sustain higher
asset prices, and mitigate the recession
I But in the ex-ante boom phase, heterogeneous beliefs exacerbate
the crash by reducing optimists’ wealth (who think the risk premium
shock is unlikely). Role for macroprudential policy.
Speculation-Drive Business Cycles
Separate set of slides based on Bigio and Zilberman (2020).

Mais Macro (IV) - Parte 3, Crenças Heterogêneas

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Mais Macro (IV) - Parte 3, Crenças Heterogêneas

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Heterogeneous Beliefs

I Finance view (textbook approach). Reference: Campbell (2018),

I A few insights from surveys: Xiong (2013, Handbook) and

I Detour. Diagnostic expectations: Gennaioli and Shleifer (2018),

I Shameless self-promotion: “Speculation-Driven Business Cycles”,

I Finance view (textbook approach). Reference: Campbell (2018),

I A few insights from surveys: Xiong (2013, Handbook) and

I Detour. Diagnostic expectations: Gennaioli and Shleifer (2018),

I Shameless self-promotion: “Speculation-Driven Business Cycles”,

Modification: allow for heterogeneous beliefs and u, but homogeneous β.

Goal. Solve the planner problem, which is something controversial in the

subject to the resources constraint for all t, s t ,

Definitions: Trader i ...

Lemma. If aggregate endowment is positive and finite, in a given history,

Proof. Another application of the martingale convergence thm. Indeed,

Corollary. If trader i has rational expectations, i.e. {πti (s t )} is equal to

Natural questions: (i) what happens to other “non-rational” traders?; (ii)

To answer these questions, simplify the environment.

Suppose a history s t in which s = 0 realized n times. Hence,

Properties: Ep (q) ≥ 0; Ep (q) = 0 if and only if q = p. It captures how

Recall that, in a given history, lim Lijt (s t ) = ∞ implies lim cti (s t ) = 0.

Hence, whenever a trader j with more accurate beliefs than trader i

Recursive preferences. Detour: Epstein and Zin (1989, 1991)

I γ interpreted as relative risk aversion; ρ is the IES and β the

Borovicka (2020). Counterpart of Epstein-Zin preferences in continuous

In terms of lung-run survival, anything can happen:

I Co-existence is not surprising: binding debt limits prevents agents

I i.e. commit their entire flow of endowments to support past

I Market structure matters. E.g., Cao (2017), in which agents are

I Somewhat more surprising: agents with correct beliefs may vanish.

Next: an example in which the agent with correct beliefs vanishes.

Example in Appendix C, Chapter 8 (Ljungqvist and Sargent, new

I Two agents, i = 1, 2: u1 (c) = c 1−γ

I for all t, s t , aggregate endowment Yt (s t ) > 0; and there exists

I for all t, s t , individual endowments (y01 (s 0 ), y02 (s 0 )) = (0, Y0 (s 0 ))

Trader i’s problem, assuming possibly different discount factors βi :

FOCs yield the Euler equations:

For i = 2, given that u2 (c) = ln(c) and yt2 (s t ) = 0 for t > 0,

2 at2 (s t ) µt (s t )bt2 (s t−1 )

Working out the Euler equation for i = 2 with γ2 = 1,

where ξti (s̃ t ) is an useful auxiliary variable: for s̃t |s t−1 ,

µt (s̃ t )[cti (s̃ t )]−γi

which has conditional mean one.

which has conditional mean one.

Market clear condition implies that:

[Yt (s̃ t )]1−γ [1 − (1 − β2 )bt2 (s t−1 )]−γ

[Yt (s̃ t )]1−γ

By imposing more structure (perfect correlation and i.i.d. shocks), we

which follows and i.i.d. process.

Hence, by iterating the former equation backwards,

Strike contrast with complete markets, in which the consumption of a

In the limit, applying the LLN to the first term:

By Jensen’s inequality, there exists ε > 0, such that

By continuity, given that {π 1 (s); s ∈ S} is sufficiently close to {π(s); s ∈ S},

Hence, for T large enough, Tj=1 ξ 1 (s̃j ) < e −εT → 0, a.s.

Small twist to show that incomplete markets can be “beneficial”:

In that sense, incomplete markets can be “beneficial,” according to the

I Since utility is defined over actual consumption, so what matters are

I Criticism against this paternalistic view. Agents might get hurt by

I An additional criticism in other normative analyses. Why does the

I Finance view (textbook approach). Reference: Campbell

I A few insights from surveys: Xiong (2013, Handbook) and

I Detour. Diagnostic expectations: Gennaioli and Shleifer (2018),

I Shameless self-promotion: “Speculation-Driven Business Cycles”,