Abstract We study the effects of central bank balance sheet policies—namely, quantitative easing and foreign exchange interventions—in a model where people form expectations through an iterative level-k thinking process. We emphasize two main theoretical results. First, under a broad set of conditions, central bank interventions are effective under level-k thinking, while they are neutral in the rational expectations equilibrium. Second, when preferences exhibit constant relative risk aversion, asset purchases increase aggregate output if they target assets with pro-cyclical returns but reduce it if asset returns are counter-cyclical. Finally, we empirically show that forecast errors about future asset prices are predictable by balance sheet interventions, a property that differentiates our channel from popular alternatives, such as portfolio-balance and signaling channels.

Abstract We study the psychological costs of financial constraints and their economic consequences. Using a representative survey of U.S. households, we document the prevalence of financial stress in U.S. households and a strong relationship between financial stress and measures of financial constraints. We incorporate financial stress into an otherwise standard dynamic model of consumption and labour supply. We emphasize two key results. First, both financial stress itself and naivete about financial stress are important components of a psychology-based theory of the poverty trap. Sophisticated households, instead, save extra to escape high-stress states because they understand that doing so alleviates the economic consequences of financial stress. Second, the financial stress channel dampens or reverses the counterfactual large negative wealth effect on labour earnings because relieving stress frees up cognitive resources for productive work. Financial stress also has macroeconomic implications for wealth inequality and fiscal multipliers.