1 Introduction 4

2 Theenvironment 9

2.1 Firms 9

2.1.1 Finalgoodproducers.10

2.1.2 Intermediategoodproducers .10

2.2 Households 11

2.2.1 Consumption-savingdecision 12

2.2.2 Labour-supplydecision 12

2.3 PhillipsandIScurves 14

2.3.1 Asymmetric,flexible-wagebenchmark 14

2.3.2 Phillipscurve 14

2.3.3 IScurve 15

2.4 Monetaryandfiscalpolicy 16

2.4.1 Centralbank 16

2.4.2 Fiscalauthority 17

2.5 Summaryofequilibriumconditions 17

3 Expectationsandoptimalpolicy 17

3.1 Expectations 18

3.1.1 Rationalexpectations(RE) 18

3.1.2 Adaptiveexpectations(AE) 18

3.1.3 Level-kthinking(LKT) 19

3.2 Optimalpolicy 20

3.2.1 OptimalpolicyunderRE(k→∞) 21

3.2.2 OptimalpolicyunderAE(k=0) 22

3.2.3 OptimalpolicyunderLKT(k∈{1,2,...}) 23

4 Dynamicpolicyproblem: numericalsolution 32

4.1 GeneralizingthePhillipscurve 32

4.2 Baselineparameterizationandsolutionmethod 33

4.3 Results. 34

5 Costs of deviating from the optimal policy 37

6 What about demand shocks? 39

7 Model mechanism and the recent inflation surge 40

8 Conclusion 44

A Proofs 48

B Demand curve under non-rational expectations 51

C Phillips curve under GHH preferences 52

D Numerical solution algorithm 55

E Hybrid Phillips curves 56

F Econometric learning 58

G Other potential specifications for level-0 beliefs 64

H Alternative models of bounded rationality 68

H.1 Reflective expectations 68

H.2 Cognitive hierarchy 70

I Oil price shocks as productivity shocks 74