DEPARTMENT OF ECONOMICS | FACULTY OF ARTS AND SCIENCES | HARVARD.EDU

Monetary Policy, Bounded Rationality, and Incomplete Markets

Citation:

Farhi, Emmanuel, and Ivan Werning. Forthcoming. “Monetary Policy, Bounded Rationality, and Incomplete Markets.” American Economic Review.

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Date Published:

2017

Abstract:

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 “forward guidance puzzle”. 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.

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