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• We present a behavioural New Keynesian model with different beliefs. • Economic fluctuations may be driven by heterogeneous expectations. • Credit cycles and inequalities in the distribution of wealth emerge endogenously. • With limits on the amount of borrowing the model generates severe crises. • Monetary policy can reduce the frequency of severe recessions. In a behavioral variant of a New Keynesian model, in which individuals use simple heuristic rules to forecast future inflation and output, if there are limits on the amount of debt that economic agents are allowed to bear, we observe occasionally severe downturns. Differences in beliefs combined with borrowing constraints tend to dampen expansions, but give rise to a chain reaction that exacerbates the recessions. The model is an example of endogenous credit cycles with expansions, severe recessions, and persistent inequality in the distribution of wealth. Monetary policy can both stabilize the economy and cause increased average output. [ABSTRACT FROM AUTHOR]

Modern theory on interest rate rules is based on the representative agent framework with infinite-horizon consumers, thereby ignoring redistributions of the fiscal burden across generations due to deficit shocks. We show how the ‘Taylor principle’ relies on this restrictive assumption. In a dynamic New Keynesian general equilibrium model with overlapping generations, the existence of a unique stable rational expectations equilibrium may also occur under a passive monetary policy. However, active monetary policy is still required to stabilize the economy in response to fiscal shocks. [ABSTRACT FROM AUTHOR]