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

Author

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  • Michał Brzoza-Brzezina
  • Paweł Galiński
  • 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 (RE) 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 (BE). In contrast, the spillovers of monetary policy are dampened. Fourth, BE contribute to solving the puzzle of excess foreign currency returns (UIP puzzle).

Suggested Citation

  • Michał Brzoza-Brzezina & Paweł Galiński & Makarski Krzysztof, 2025. "Monetary and fiscal policy in a two-country model with behavioral expectations," KAE Working Papers 2025-110, Warsaw School of Economics, Collegium of Economic Analysis.
    • Handle: RePEc:sgh:kaewps:2025110
    DOI: 10.33119/kaewps2025110
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    File URL: https://hdl.handle.net/20.500.12182/1330
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    2. 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).

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    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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