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Monetary and fiscal policy in a two-country model with behavioral expectations

Author

Listed:
  • Brzoza-Brzezina, Michał
  • Galiński, Paweł R.
  • Makarski, Krzysztof

Abstract

We check how monetary and fiscal policies (in particular their open-economy dimensions) are affected by expectations being behavioral in the spirit of Gabaix (2020). We first show that the data strongly favor this setting compared with the standard rational expectations assumption. Then we document several novel findings. First, monetary policy is less powerful and faces a higher sacrifice ratio when agents are behavioral. Second, the Taylor principle is affected: determinacy regions are larger if the economy is more open or the central bank abroad is more hawkish. Third, fiscal policy and its international spillovers are amplified under behavioral expectations. In contrast, the spillovers of monetary policy are dampened. Fourth, behavioral expectations contribute to solving the puzzle of excess foreign currency returns (UIP puzzle).

Suggested Citation

  • Brzoza-Brzezina, Michał & Galiński, Paweł R. & Makarski, Krzysztof, 2025. "Monetary and fiscal policy in a two-country model with behavioral expectations," Journal of International Money and Finance, Elsevier, vol. 155(C).
    • Handle: RePEc:eee:jimfin:v:155:y:2025:i:c:s026156062500066x
    DOI: 10.1016/j.jimonfin.2025.103331
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    More about this item

    Keywords

    Behavioral agents; Monetary policy; Open-economy model;
    All these keywords.

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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