Misspecified expectations in an open economy

In the past two decades, Turkey has experienced multiple changes in its monetary policy regime. To analyse how these policy changes affect the behaviours of households and firms, some behavioural parameters are incorporated into a small open economy New Keynesian model. Our approach consists of four phases. First, we assess the impacts of the behavioural parameters on the model and find that higher values of the parameters increase the effects of expectations on the model. Second, for the period between 2006 and 2021, the model is estimated for the Turkish economy and the findings show that both households and firms are more forward-looking in their decision making. Moreover, the current variables have a weak effect on the nominal interest rate, and the inertial nominal interest rate has a strong effect on it. Third, we analyse the evolution of the model parameters over the period and find that the behavioural parameters tend to increase, while the monetary policy becomes more inertial. Finally, we conclude that the Central Bank should follow Domestic Inflation-based Taylor rule to minimise welfare loss.