Expectations Formation, Sticky Prices, and the ZLB
38 Pages Posted: 11 Nov 2019
Date Written: 2019
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: Suggested Citation