Optimal monetary policy under bounded rationality

Jonathan Benchimol and Lahcen Bounader

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Abstract: We develop a behavioral New Keynesian model to analyze optimal monetary policy with heterogeneously myopic households and firms. Five key results are derived. First, our model reflects coherent microeconomic and aggregate myopia due to the consistent transition from subjective to objective expectations. Second, the optimal monetary policy entails implementing inflation targeting in a framework where myopia distorts agents' inflation expectations. Third, price level targeting emerges as the optimal policy under output gap, revenue, or interest rate myopia. Under price level targeting, rational inflation expectations are a minimal condition for optimality under bounded rationality. Fourth, bounded rationality is not necessarily welfare-decreasing and is even associated with welfare gains for extreme cognitive discounting. Finally, our empirical results point to the behavioral model's superiority over the rational model.

Keywords: Behavioral macroeconomics; Central bank policy; Cognitive discounting; Heterogeneous expectations; Optimal simple rules (search for similar items in EconPapers)
Date: 2023-08
Note: View the original document on HAL open archive server: https://hal-emse.ccsd.cnrs.fr/emse-04624979v1
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Published in Journal of Financial Stability, 2023, 67 (101151), pp.1-25. ⟨10.1016/j.jfs.2023.101151⟩

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Related works:
Journal Article: Optimal monetary policy under bounded rationality (2023)
Working Paper: Optimal Monetary Policy Under Bounded Rationality (2021)
Working Paper: Optimal Monetary Policy under Bounded Rationality (2019)
Working Paper: Optimal Monetary Policy Under Bounded Rationality (2019)
Working Paper: Optimal Monetary Policy Under Bounded Rationality (2018)
Working Paper: Optimal monetary policy under bounded rationality (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:emse-04624979

DOI: 10.1016/j.jfs.2023.101151

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