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Monetary policy and exchange rate dynamics in a behavioral open economy model

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Listed:
  • Kolasa, Marcin
  • Ravgotra, Sahil
  • Zabczyk, Pawel

Abstract

We analyze the implications of adding boundedly rational agents á la Gabaix (2020) to the canonical New Keynesian open economy model. We show that accounting for myopia mitigates several “puzzling” aspects of the relationship between exchange rates and interest rates and helps explain why some of them only arise in the nested case of rational expectations. Bayesian estimation of the model demonstrates that a high degree of “cognitive discounting” significantly improves empirical fit. We also show that this form of bounded rationality makes positive international monetary spillovers more likely and exacerbates the unit root problem in small open economy models with incomplete markets.

Suggested Citation

  • Kolasa, Marcin & Ravgotra, Sahil & Zabczyk, Pawel, 2025. "Monetary policy and exchange rate dynamics in a behavioral open economy model," Journal of International Economics, Elsevier, vol. 155(C).
    • Handle: RePEc:eee:inecon:v:155:y:2025:i:c:s0022199625000431
    DOI: 10.1016/j.jinteco.2025.104087
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    Keywords

    Monetary policy; Exchange rates; UIP condition; Bounded rationality;
    All these keywords.

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G40 - Financial Economics - - Behavioral Finance - - - General

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