@article {503421,
	title = {Monetary Policy, Bounded Rationality, and Incomplete Markets},
	journal = {American Economic Review},
	year = {Forthcoming},
	month = {2017},
	abstract = {\&nbsp;This paper extends the benchmark New-Keynesian model with a representative agent and rational expectations by introducing two key frictions: (1) incomplete markets with 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 much more pronounced at long horizons. This offers a potential rationalization of the {\textquotedblleft}forward guidance puzzle{\textquotedblright}. Each of these frictions, in isolation, would lead to no or much smaller departures from the benchmark model. We conclude that the interaction of bounded rationality and is important.\&nbsp;},
	author = {Emmanuel Farhi and Ivan Werning}
}
