Bounded rationality, monetary policy, and the scars of supply shocks

Bounded rationality reshapes monetary-policy trade-offs in response to supply shocks in a New Keynesian model with endogenous growth. A negative supply shock depresses innovation and future productivity, which gives rise to long-run scarring and persistent inflationary pressures. Under rational expectations, tighter monetary policy eases the initial rise in inflation but amplifies the fall in demand, innovation, and productivity. Under bounded rationality, households underreact to future income losses. This weakens the negative wealth effect and mitigates the decline in demand and growth. As a result, tighter monetary policy can contain inflation without generating large scarring effects.