The Importance of Diagnostic Expectations in Open Economies

IMF Working Papers, November 21, 2025

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Development and estimation of a parsimonious New-Keynesian small open-economy model that incorporates Diagnostic Expectations (DE)—a behavioral alternative to Rational Expectations (RE).
Under DE, agents systematically overreact to new information, generating additional endogenous volatility.
Empirical analysis provides robust support for the DE framework: it fits Canadian data significantly better than the nested RE benchmark and improves forecasts of key macroeconomic variables, including real GDP growth, even during crises such as the Global Financial Crisis.
DE reshapes the transmission of shocks, amplifying their effects and strengthening the exchange-rate channel of monetary policy.
The relative importance of structural shocks shifts under DE—with greater roles for supply shocks—and policymakers face a meaningfully worse inflation–output volatility trade-off.
Overall conclusion: behavioral expectations are relevant for open-economy dynamics and policy design.

The DE model fits Canadian data significantly better than the nested RE benchmark.
Forecasting performance improves for key macroeconomic variables, explicitly including real GDP growth, even during crisis periods such as the Global Financial Crisis.
Diagnostic Expectations generate additional endogenous volatility through systematic overreaction to new information.
Transmission channels altered by DE include an amplified role for the exchange-rate channel of monetary policy.
Structural shock importance changes under DE, with supply shocks taking on greater roles.
Policy trade-offs deteriorate: policymakers face a meaningfully worse inflation–output volatility trade-off under DE compared with RE.

Behavioral rule: Diagnostic Expectations imply systematic overreaction to new information by agents.
Endogenous volatility: Overreaction generates additional internally driven volatility in macroeconomic variables.
Shock transmission: DE amplifies shock effects and strengthens exchange-rate transmission of monetary policy.
Structural decomposition: Shift in relative importance of structural shocks (greater role for supply shocks).
Policy environment: Amplified responses and altered shock structure worsen the inflation–output volatility trade-off faced by policymakers.

Recognize behavioral expectations: Monetary and fiscal policy design in open economies should account for Diagnostic Expectations as a realistic expectations formation mechanism.
Reassess policy trade-offs: Policymakers should anticipate a worse inflation–output volatility trade-off when agents form Diagnostic Expectations rather than Rational Expectations.
Consider exchange-rate channel potency: Policy strategies that rely on exchange-rate transmission need to account for strengthened exchange-rate effects under DE.
Model adoption: Use of models incorporating DE can improve forecasting and policy evaluation, particularly during crisis episodes.