Monetary Policy, Bounded Rationality, and Incomplete Markets
This paper extends the benchmark New-Keynesian model by introducing two 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 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.
Document Object Identifier (DOI): 10.3386/w23281
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