Dampening General Equilibrium: Incomplete Information and Bounded Rationality

We review how realistic frictions in information and/or rationality arrest general equilibrium (GE) feedbacks. In one specification, we maintain rational expectations but remove common knowledge of aggregate shocks. In another, we replace rational expectations with Level-k Thinking or a smooth variant thereof. Two other approaches, heterogeneous priors and cognitive discounting, capture the same essence while offering a gain in tractability. Relative to the full-information rational-expectation (FIRE) benchmark, all these modifications amount to attenuation of GE effects, especially in the short run. This in turn translates to either under- or over-reaction in aggregate outcomes, depending on whether GE feedbacks are positive or negative in the first place. We review a few applications, with emphasis on monetary and fiscal policy. We finally discuss how the available evidence on expectations, along with other considerations, can help guide the choice among the various alternatives, as well as between them and FIRE.