Monetary Policy, Bounded Rationality, and Incomplete Markets
- American Economic Review (Forthcoming)
This paper extends the benchmark New-Keynesian model by introducing two frictions:
(1) agent heterogeneity with incomplete markets, uninsurable idiosyncratic risk, and occasionallybinding
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.
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