Monetary Policy, Bounded Rationality, and Incomplete Markets

56 Pages Posted: 27 Mar 2017

See all articles by Emmanuel Farhi

Emmanuel Farhi

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Iván Werning

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: March 2017

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.

Suggested Citation

Farhi, Emmanuel and Werning, Ivan, Monetary Policy, Bounded Rationality, and Incomplete Markets (March 2017). NBER Working Paper No. w23281, Available at SSRN: https://ssrn.com/abstract=2941259

Emmanuel Farhi (Contact Author)

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Ivan Werning

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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