Impact of bounded rationality on monetary policy
Xavier Gabaix uses a behavioral New Keynesian model to analyze monetary and fiscal policy when the agent is partially myopic to unusual events and does not anticipate the future perfectly. He finds that:
- The Taylor principle is strongly modified;
- The model can explain the stability of economies stuck at the zero lower bound (ZLB) something that is difficult to achieve in traditional models;
- The ZLB is much less costly;
- Forward guidance is much less powerful than in the traditional model, offering a natural behavioral resolution of the “forward guidance puzzle”;
- Optimal policy changes qualitatively: for instance, the optimal commitment policy with rational firms demands “price level targeting”. This is not the case with behavioral firms;
- A number of neo-Fisherian paradoxes are resolved. A permanent rise in the nominal interest rate causes inflation to fall in the short run (a Keynesian effect) and rise in the long run (so that long-run Fisher neutrality holds with respect to inflation);
- Fiscal policy is much more powerful than in the traditional model. In the present behavioral model, agents are partly myopic, and consume more when they receive tax cuts or “helicopter drops of money” from the central bank.
A Behavioral New Keynesian Model
Author: Xavier Gabaix
From: Harvard University
Myopia and the Taylor rule
Benchimol and Bounader also use a behavioral New Keynesian model to investigate the dependence of optimal monetary policy on specific myopias characterizing households and firms. Their findings include:
- The optimal monetary policy in the presence of myopia entails implementing inflation targeting;
- There are no feasible instrument rules for implementing the optimal monetary policy, casting doubt on the ability of simple Taylor rules to assist in the setting of monetary policy.
Optimal monetary policy under bounded rationality
Authors: Jonathan Benchimol, Lahcen Bounader
From: Bank of Israel, IMF
