Equilibrium with computationally constrained agents

This paper studies aggregate equilibrium models where firms cannot compute future prices with perfect accuracy. Instead, firms use approximations to infer prices. In equilibrium, we find that the precision with which firms can compute prices is endogenous and depends on the level of aggregate supply. At the same time, firms’ individual supplies, and thus aggregate supply, depend on the precision with which future prices are computed. This interplay between supply and firms’ individual ability to infer prices induces multiple equilibria, with inefficiently low output, in economies that otherwise have a unique, efficient, rational expectations equilibrium. Moreover, exogenous parameter changes, which would increase output were there no computational frictions, can diminish the precision of agents’ price forecasts, and reduce output. Our model also accommodates the intuition that large interventions, such as unprecedented quantitative easing, can put agents into “uncharted territory.”