Abstract

At the zero lower bound (ZLB), expectations about the future path of monetary or fiscal policy are crucial. We model expectations formation under level-k thinking, a form of bounded rationality formalized by García-Schmidt and Woodford (2019) and Farhi and Werning (2019), consistent with experimental evidence. This process does not lead to a number of puzzling features from rational expectations models, such as the reversal puzzle, or implausible large fiscal multipliers. Optimal monetary policy at the ZLB under level-k thinking prescribes keeping the nominal rate lower for longer, but short-run macro-economic stabilization is less powerful compared to rational expectations.