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Bounded rationality and macroeconomic (in)stability

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  • Gurrola Luna, Alejandro
  • McKnight, Stephen

Abstract

We analyze how bounded rationality affects the determinacy properties of forecast-based interest-rate rules in a behavioral New Keynesian model with limited asset market participation (LAMP). We show that the conventional wisdom for achieving equilibrium uniqueness under rational expectations – adherence to the Taylor principle with low/moderate LAMP, while adopting a passive policy under high LAMP – does not carry over to more realistic frameworks with myopic agents. Under moderate participation rates, the combination of myopia and LAMP have a destabilizing effect on the economy by helping to induce indeterminacy under the Taylor principle. In contrast, myopia plays a key stabilizing role in high LAMP economies, where a passive policy is no longer required to prevent indeterminacy, and determinacy under the Taylor principle can be restored. We investigate the sensitivity of our results to a policy response to output; alternative forms of bounded rationality; and the inclusion of a cost-channel of monetary policy.

Suggested Citation

  • Gurrola Luna, Alejandro & McKnight, Stephen, 2026. "Bounded rationality and macroeconomic (in)stability," Economic Modelling, Elsevier, vol. 155(C).
    • Handle: RePEc:eee:ecmode:v:155:y:2026:i:c:s0264999325004237
    DOI: 10.1016/j.econmod.2025.107428
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    Keywords

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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E71 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on the Macro Economy

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