Monetary Policy, Bounded Rationality, and Incomplete Markets
- (pp. 3887-3928)
Abstract
This paper extends the benchmark New-Keynesian model by introducing two frictions: (i) agent heterogeneity with incomplete markets, uninsurable idiosyncratic risk, and occasionally-binding borrowing constraints; and (ii) 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.Citation
Farhi, Emmanuel, and Iván Werning. 2019. "Monetary Policy, Bounded Rationality, and Incomplete Markets." American Economic Review, 109 (11): 3887-3928. DOI: 10.1257/aer.20171400Additional Materials
JEL Classification
- D52 Incomplete Markets
- D81 Criteria for Decision-Making under Risk and Uncertainty
- E12 General Aggregative Models: Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
- E52 Monetary Policy