Exchange Rate Expectations and Aggregate Dynamics

The paper explores the role expectations play in the economy’s response to exchange rate fluctuations. Using data fr om the Central Reserve Bank of Peru, I analyze firm-level exchange rate forecasts and find that firms deviate from rational expectations by over reacting to new information and overestimating the persistence of the current exchange rate. I also demonstrate that firms that anticipate depreciation are more likely to reduce employment and production. Based on these observations, I develop the behavioral general equilibrium model of a small open economy wh ere the exchange rate is driven by a financial shock to the uncovered interest parity condition. Firms set their prices infrequently and associate expected depreciation with a higher future path of marginal costs. They overestimate the persistence of the shock and contract their economic activity more than under the rational expectations benchmark, potentially reversing the sign of the aggregate output response. If households and financial institutions share this bias, the impact of the shock becomes amplified, contributing to greater exchange rate volatility