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Monetary Policy, Bounded Rationality, and Incomplete Markets

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  • Emmanuel Farhi
  • Iván Werning

Abstract

This paper extends the benchmark New-Keynesian model with a representative agent and rational expectations 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. We conclude that the interaction of bounded rationality and market frictions improves the ability of the model to account for the effects of monetary policy.

Suggested Citation

  • Emmanuel Farhi & Iván Werning, 2017. "Monetary Policy, Bounded Rationality, and Incomplete Markets," NBER Working Papers 23281, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:23281
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    References listed on IDEAS

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    1. Oh, Hyunseung & Reis, Ricardo, 2012. "Targeted transfers and the fiscal response to the great recession," Journal of Monetary Economics, Elsevier, vol. 59(S), pages 50-64.
    2. Greg Kaplan & Giovanni L. Violante, 2014. "A Model of the Consumption Response to Fiscal Stimulus Payments," Econometrica, Econometric Society, vol. 82(4), pages 1199-1239, July.
    3. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-247, April.
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    Cited by:

    1. Mark Gertler, 2017. "Rethinking the Power of Forward Guidance: Lessons from Japan," IMES Discussion Paper Series 17-E-08, Institute for Monetary and Economic Studies, Bank of Japan.
    2. Lawrence Christiano, 2017. "Comment on "Michelson-Morley, Fisher, and Occam: The Radical Implications of Stable Quiet Inflation at the Zero Bound"," NBER Chapters,in: NBER Macroeconomics Annual 2017, volume 32 National Bureau of Economic Research, Inc.
    3. Gerke, Rafael & Giesen, Sebastian & Kienzler, Daniel & Tenhofen, Jörn, 2017. "Interest-rate pegs, central bank asset purchases and the reversal puzzle," Discussion Papers 21/2017, Deutsche Bundesbank.
    4. Massenot, Baptiste, 2018. "A business cycle model with neuroeconomic foundations," SAFE Working Paper Series 194, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    5. P. Andrade & G. Gaballo & E. Mengus & B. Mojon, 2015. "Forward Guidance and Heterogeneous Beliefs," Working papers 573, Banque de France.
    6. George-Marios Angeletos, 2017. "Frictional Coordination," NBER Working Papers 24178, National Bureau of Economic Research, Inc.
    7. Xavier Gabaix, 2017. "Behavioral Inattention," NBER Working Papers 24096, National Bureau of Economic Research, Inc.
    8. George-Marios Angeletos & Chen Lian, 2017. "Dampening General Equilibrium: From Micro to Macro," NBER Working Papers 23379, National Bureau of Economic Research, Inc.

    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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