Bounded Rationality and Macroeconomic (In)Stability

Alejandro Gurrola Luna () and Stephen McKnight
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Alejandro Gurrola Luna: HSBC Mexico

Serie documentos de trabajo del Centro de Estudios Económicos from El Colegio de México, Centro de Estudios Económicos

Abstract: We analyze how bounded rationality affects the equilibrium determinacy properties of forecast-based interest-rate rules in a behavioural New Keynesian model with limited asset market participation (LAMP). We show that the key policy prescriptions of rational expectation models do not carry over to behavioural frameworks with myopic agents. In high participation economies, the Taylor principle is more likely to induce indeterminacy when bounded rationality is introduced following the cognitive discounting approach of Gabaix (2020). Indeterminacy arises from a discounting channel and the problem is exacerbated under flexible prices and nominal illusion. In contrast, cognitive discounting plays a stabilizing role in LAMP economies, where passive policy is no longer required to prevent indeterminacy, and determinacy can potentially be restored under the Taylor principle. We investigate how our results depend on the timing of the interest-rate rule, alternative forms of bounded rationality, and the presence of a cost-channel of monetary policy.

Keywords: Bounded rationality; Cognitive discounting; Equilibrium determinacy; Limited asset markets participation; Taylor principle; Monetary policy (search for similar items in EconPapers)
JEL-codes: E31 E32 E44 E52 E71 (search for similar items in EconPapers)
Date: 2025-02
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:emx:ceedoc:2025-02

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