## The Importance of Diagnostic Expectations in Open Economies

_IMF Working Papers, November 21, 2025_

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**Canonical URL:** [The Importance of Diagnostic Expectations in Open Economies](https://www.imf.org/en/publications/wp/issues/2025/11/21/the-importance-of-diagnostic-expectations-in-open-economies-572011)

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## Bibliographic details
- Authors: Selim A Elekdag, Mananirina Razafitsiory, Luis-Felipe Zanna
- Published: November 21, 2025
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9798229031943.001

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### Summary
- 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.

### Key empirical findings
- 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.

### Mechanisms and model implications
- 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.

### Policy implications and recommendations
- 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2025/11/21/the-importance-of-diagnostic-expectations-in-open-economies-572011_