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Monetay Policy, Bounded Rationality, and Incomplete Markets

Author

Listed:
  • Emmanuel Farhi

    (Harvard University)

  • Ivan Werning

    (Massachusetts Institute of Technology)

Abstract

This paper extends the benchmark New-Keynesian model by introducing two key 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 much 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

  • Emmanuel Farhi & Ivan Werning, 2018. "Monetay Policy, Bounded Rationality, and Incomplete Markets," 2018 Meeting Papers 768, Society for Economic Dynamics.
    • Handle: RePEc:red:sed018:768
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    References listed on IDEAS

    as
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    More about this item

    JEL classification:

    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E1 - Macroeconomics and Monetary Economics - - General Aggregative Models
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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