Overreaction and macroeconomic fluctuation of the external balance

Abstract

We incorporate diagnostic expectations (DE) into small open economy (SOE) models to offer novel insights into business cycles, especially in emerging countries. DE induce overreactions in domestic absorption, leading to countercyclical external balances and endogenous boom-bust cycles driven by surprises rooted in distant memory. This framework offers a cognitive alternative to permanent income shock in conventional SOE models under rational expectations (RE). Using Argentine macro-international data, we estimate a quantitative SOE-RBC model with DE that captures the volatility and cyclicality specific to emerging countries and identifies diagnosticity levels consistent with prior research, and reduces reliance on trend-driven TFP shocks. Our findings highlight DE as an empirically plausible mechanism, enriching the literature by demonstrating how imperfect, memory-based expectations influence macroeconomic dynamics in an open economy context.