Working Paper: NBER ID: w23281
Authors: Emmanuel Farhi; Iván Werning
Abstract: 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.
Keywords: Monetary Policy; Bounded Rationality; Incomplete Markets
JEL Codes: E03; E1; E4; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| agent heterogeneity (incomplete markets and borrowing constraints) + bounded rationality (level-k thinking) (D80) | mitigation effect (E71) |
| mitigation effect (E71) | sensitivity of current output to future interest rate changes (E43) |
| future interest rate changes (E43) | horizon effect (F01) |
| agent heterogeneity (incomplete markets and borrowing constraints) + bounded rationality (level-k thinking) (D80) | sensitivity of current output to future interest rate changes (E43) |