Level-k DSGE and Monetary Policy

This paper develops a new framework of level-k DSGE for monetary policy analysis. Incomplete markets are introduced to guarantee the eductive stability of the equilibrium. k=1.334 is estimated using growth and inflation forecasts from the Michigan Survey of Consumers, capturing the missing indirect channels and the weakened direct channels in households’ forecast rules, as well as the wedge between forecasts and realizations. The model produces inflation inertia under Taylor Rule. In pre-Volcker era, more active GDP targeting generates more output mean reversion both in forecasts and in realizations. In Great Recession, the model can explain the missing drop of both inflation and inflation expectations, as well as the stagnant recovery expectations that leads to slow recovery. The model also implies both dampening and accumulation effects of forward guidance. When k goes to infinity, the level-k DSGE reduces to a basic three equation New Keynesian DSGE model as in Gali (2015).