TY - JOUR AU - Farhi, Emmanuel AU - Werning, Iván TI - Monetary Policy, Bounded Rationality, and Incomplete Markets JF - National Bureau of Economic Research Working Paper Series VL - No. 23281 PY - 2017 Y2 - March 2017 DO - 10.3386/w23281 UR - http://www.nber.org/papers/w23281 L1 - http://www.nber.org/papers/w23281.pdf N1 - Author contact info: Emmanuel Farhi Harvard University E-Mail: *NA user is deceased Iván Werning Department of Economics, E52-536 MIT 77 Massachusetts Avenue Cambridge, MA 02139 Tel: 617/452-3662 Fax: 617/253-1330 E-Mail: iwerning@mit.edu AB - 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. ER -