Monetary Policy, Bounded Rationality, and Incomplete Markets
American Economic Review · 2019 · Volume 109 · Issue 11
Abstract
This paper extends the benchmark New-Keynesian model by introducing two frictions: (i) agent heterogeneity with incomplete markets, uninsurable idiosyncratic risk, and occasionally-binding borrowing constraints; and (ii) 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.
Keywords
Incomplete Markets, Criteria for Decision-Making under Risk and Uncertainty, General Aggregative Models: Keynes, Keynesian, Post-Keynesian, Modern Monetary Theory, Monetary Policy
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