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Make-up strategies with incomplete markets and bounded rationality

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  • Dobrew, Michael
  • Gerke, Rafael
  • Giesen, Sebastian
  • Röttger, Joost

Abstract

We study the impact of market incompleteness and bounded rationality on the effectiveness of make-up strategies. To do so, we simulate a heterogeneous-agent New Keynesian (HANK) model with reflective expectations and an occasionally-binding effective lower bound (ELB) on the policy rate. Our simulations show that make-up strategies can mitigate the negative consequences of the ELB for inflation and real economic activity. This result holds both for our HANK model as well as a corresponding representative-agent (RANK) model with complete markets, suggesting that market (in)completeness is not important for the effectiveness of make-up strategies. However, the stabilisation benefits of make-up strategies are small when agents' cognitive ability is consistent with micro-evidence. This result is independent of market (in)completeness, emphasising the importance of rational expectations for make-up strategies. Furthermore, while market incompleteness and bounded rationality complement each other in attenuating the effects of forward guidance in our model, we do not observe such a complementarity with respect to the benefits of make-up strategies.

Suggested Citation

  • Dobrew, Michael & Gerke, Rafael & Giesen, Sebastian & Röttger, Joost, 2023. "Make-up strategies with incomplete markets and bounded rationality," Discussion Papers 01/2023, Deutsche Bundesbank.
    • Handle: RePEc:zbw:bubdps:012023
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    1. Kopiec, Paweł, 2024. "Monetary-Fiscal Forward Guidance," MPRA Paper 120563, University Library of Munich, Germany.

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    More about this item

    Keywords

    Make-Up Strategies; Incomplete Markets; Bounded Rationality; HANK; Effective Lower Bound; Average Inflation Targeting;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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