Expectations Formation, Sticky Prices, and the ZLB

38 Pages Posted: 11 Nov 2019

See all articles by Betsy Bersson

Betsy Bersson

Duke University

Patrick Hürtgen

Deutsche Bundesbank

Matthias O. Paustian

Board of Governors of the Federal Reserve System

Date Written: 2019

Abstract

At the zero lower bound (ZLB), expectations about the future path of monetary or fiscal policy are crucial. We model expectations formation under level-k thinking, a form of bounded rationality introduced by García-Schmidt and Woodford (2019) and Farhi and Werning (2017), consistent with experimental evidence. This process does not lead to a number of puzzling features from rational expectations models, such as the forward guidance and the reversal puzzle, or implausible large fiscal multipliers. Optimal monetary policy at the ZLB under level-k thinking prescribes keeping the nominal rate lower for longer, but short-run macroeconomic stabilization is less powerful compared to rational expectations.

Keywords: expectations formation, optimal monetary policy, New Keynesian model, zero lower bound, forward guidance puzzle, reversal puzzle, fiscal multiplier

JEL Classification: E32

Suggested Citation

Bersson, Betsy and Hürtgen, Patrick and Paustian, Matthias O., Expectations Formation, Sticky Prices, and the ZLB (2019). Deutsche Bundesbank Discussion Paper No. 34/2019, Available at SSRN: https://ssrn.com/abstract=3473029

Betsy Bersson (Contact Author)

Duke University

100 Fuqua Drive
Durham, NC 27708-0204
United States

Patrick Hürtgen

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Matthias O. Paustian

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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