Monetary Policy, Bounded Rationality, and Incomplete Markets

By Emmanuel Farhi, I. Werning. The American Economic Review, 2019

266 citations recorded by the source corpus.

This paper extends the benchmark New-Keynesian model by introducing two frictions: (i) agent heterogeneity with incomplete markets, uninsurable idiosyncratic risk, and occasionally-binding borrowing constraints; and (ii) 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. (JEL D52, D81, E12, E52)

Subfields: Economics and Econometrics

View Paper: https://www.semanticscholar.org/paper/109e8a4d29d76cf42d60f6ffd81fbad228791e3f

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Citations in the corpus

Five Facts about Beliefs and Portfolios (2019, background): “6In part based on this evidence, there is growing interest in macroeconomic theory with a strong behavioral content (e.g., Gabaix, 2016; Farhi and Werning, 2017; García-Schmidt and Woodford, 2019).”
A Behavioral New Keynesian Model (2020, unknown): “What is the impact at time 0 of a one-period fall of the real interest rate r̂τ , in partial and general equilibrium, in both the rational and the behavioral model (as in Angeletos and Lian (2017a) and Farhi and Werning (2017))? For simplicity, I take r̂ τ = 0 here.”
Exogenous Cost Allocation in Peer-to-Peer Electricity Markets (2019, background): “In addition, game theory studies on bounded rationality, as in [28], [29], still hold but might need some adaptations.”