Monetary Policy, Bounded Rationality, and Incomplete Markets

Emmanuel Farhi and Iván Werning

No 23281, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: E03 E1 E4 E52 (search for similar items in EconPapers)
Date: 2017-03
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (63)

Published as Emmanuel Farhi & Iván Werning, 2019. "Monetary Policy, Bounded Rationality, and Incomplete Markets," American Economic Review, vol 109(11), pages 3887-3928.

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Related works:
Journal Article: Monetary Policy, Bounded Rationality, and Incomplete Markets (2019)
Working Paper: Monetay Policy, Bounded Rationality, and Incomplete Markets (2018)
Working Paper: Monetary Policy, Bounded Rationality, and Incomplete Markets (2017)
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