Monetary Policy, Bounded Rationality, and Incomplete Markets

Emmanuel Farhi, Iván Werning

NBER Working Paper No. 23281
Issued in March 2017, Revised in February 2019
NBER Program(s):Economic Fluctuations and Growth, Monetary Economics

This paper extends the benchmark New-Keynesian model by introducing two frictions: (1) agent heterogeneity with incomplete markets, uninsurable idiosyncratic risk, and occasionally binding borrowing constraints; and (2) bounded rationality in the form of level-k thinking. Compared to the benchmark model, we show that the interaction of these two frictions leads to a powerful mitigation of the effects of monetary policy, which is more pronounced at long horizons, and offers a potential rationalization of the “forward guidance puzzle”. Each of these frictions, in isolation, would lead to no or much smaller departures from the benchmark model.

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w23281

Published: Emmanuel Farhi & Iván Werning, 2019. "Monetary Policy, Bounded Rationality, and Incomplete Markets," American Economic Review, vol 109(11), pages 3887-3928. citation courtesy of