Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/262208 
Year of Publication: 
2022
Series/Report no.: 
DIW Discussion Papers No. 1995
Version Description: 
Updated Version, August 2022
Publisher: 
Deutsches Institut für Wirtschaftsforschung (DIW), Berlin
Abstract: 
We develop a New Keynesian model with household heterogeneity and bounded rationality in the form of cognitive discounting. The interaction of household heterogeneity and bounded rationality generates amplification of monetary and fiscal policy through indirect general equilibrium effects while simultaneously ruling out the forward guidance puzzle and remaining stable at the effective lower bound. Thus, the model can account for recent empirical findings on the transmission mechanisms and effectiveness of monetary and fiscal policy. When abstracting from either household heterogeneity or bounded rationality the model fails to do so. Our framework nests a broad range of existing models, none of which can be consistent with all these empirical facts simultaneously. According to our model, central banks have to increase interest rates more strongly than in the rational model after an inflationary supply shock to fully stabilize inflation. While fully stabilizing inflation keeps output at potential, higher real interest rates mainly benefit wealthy households and increase the cost of government debt, leading to a substantial increase in government debt and inequality. Our model thus indicates a more pronounced trade off between aggregate efficiency and price stability on one hand, and distributional consequences and fiscal sustainability on the other hand.
Subjects: 
Heterogeneous Households
Behavioral Macroeconomics
Monetary Policy
Forward Guidance
Fiscal Policy
Lower Bound
Inflation
Macroeconomic Stabilization
JEL: 
E21
E52
E62
E71
Document Type: 
Working Paper

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