A behavioral hybrid New Keynesian model: Quantifying the importance of belief formation frictions

Recent evidence points towards significant belief formation frictions and forecast sluggishness. In this paper, we build a bounded rationality New Keynesian model, estimated to match the degree of forecast sluggishness present in the data. We find that bounded rationality induces enough myopia and intrinsic persistence, diminishing the influence of consumption habits and price indexation. Additionally, the bounded rationality model generates impulse response dynamics to monetary policy shocks that resemble those observed in empirical estimations. This study highlights the significance of bounded rationality in capturing real-world dynamics and provides valuable insights into the role of belief formation frictions in macroeconomic modeling.