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Expectations Formation, Sticky Prices, and the ZLB

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  • ELIZABETH BERSSON
  • PATRICK HÜRTGEN
  • MATTHIAS PAUSTIAN

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$k$ thinking, a form of bounded rationality formalized by García‐Schmidt and Woodford (2019) and Farhi and Werning (2019), consistent with experimental evidence. This process does not lead to a number of puzzling features from rational expectations models, such as the reversal puzzle, or implausible large fiscal multipliers. Optimal monetary policy at the ZLB under level‐k$k$ thinking prescribes keeping the nominal rate lower for longer, but short‐run macro‐economic stabilization is less powerful compared to rational expectations.

Suggested Citation

  • Elizabeth Bersson & Patrick Hürtgen & Matthias Paustian, 2024. "Expectations Formation, Sticky Prices, and the ZLB," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(2-3), pages 365-393, March.
    • Handle: RePEc:wly:jmoncb:v:56:y:2024:i:2-3:p:365-393
    DOI: 10.1111/jmcb.13065
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    References listed on IDEAS

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