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Optimal Monetary Policy under Bounded Rationality

Jonathan Benchimol () and Lahcen Bounader

No 2019.07, Bank of Israel Working Papers from Bank of Israel

Abstract: A​bstract We build a behavioral New Keynesian model that emphasizes different forms of myopia for households and firms. By examining the optimal monetary policy within this model, we find four main results. First, in a framework where myopia distorts agents' inflation expectations, the optimal monetary policy entails implementing inflation targeting. Second, price level targeting emerges as the optimal policy under output gap, revenue, or interest rate myopia. Given that bygones are not bygones under price level targeting, rational inflation expectations are a minimal condition for optimality in a behavioral world. Third, we show that there are no feasible instrument rules for implementing the optimal monetary policy, casting doubt on the ability of simple Taylor rules to assist in the setting of monetary policy. Fourth, bounded rationality may be associated with welfare gains.

New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-upt
Date: 2019-07
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Related works:
Working Paper: Optimal Monetary Policy Under Bounded Rationality (2019) Downloads
Working Paper: Optimal monetary policy under bounded rationality (2018) Downloads
Working Paper: Optimal Monetary Policy Under Bounded Rationality (2018) Downloads
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