A Behavioral Heterogeneous Agent New Keynesian Model

Recent empirical evidence has led to a rethinking of how monetary policy is transmitted to the economy: (i) monetary policy influences household consumption to a large extent through indirect general equilibrium effects; (ii) households with higher marginal propensities to consume are on average more exposed to monetary policy; (iii) announcements of future monetary policy changes have relatively weak effects on current economic activity; and (iv) the effective lower bound on nominal interest rates does not lead to large instabilities. We develop a New Keynesian model with household heterogeneity and bounded rationality in the form of cognitive discounting that accounts for all these facts simultaneously. In contrast to existing models, we jointly account for these facts without having to rely on a specific monetary or fiscal policy. We use our model to revisit the policy implications of inflationary supply shocks and find a pronounced trade-off between price stability on the one hand, and fiscal and distributional consequences on the other hand. Monetary policy has to increase interest rates more strongly than under rational expectations to fully stabilize inflation. This leads to a stronger increase in consumption inequality and has larger fiscal implications. When monetary policy follows a standard Taylor rule, inequality declines after the negative supply shock. Inflation, however, increases substantially due to a novel amplification channel driven by cognitive discounting, household heterogeneity and the interaction of the two.