Monetary Policy and Exchange Rate Dynamics in a Behavioural Open Economy Model

We develop and estimate an extension of the open economy New Keynesian model in which agents are boundedly rational _a la Gabaix (2020). Our setup successfully mitigates many puzzling aspects of the relationship between exchange rates and interest rates, and remains consistent with recent empirical evidence showing that UIP puzzles vanish when actual - as opposed to rational - exchange rate expectations are used. We find that accounting for myopia dampens the effects of current monetary shocks and lowers the efficacy of forward guidance (FG), but its relative importance in mitigating the “FG puzzle" is decreasing in openness. We also show that bounded rationality makes positive monetary spillovers more likely, increases the persistence of the real exchange rate and net foreign assets, and exacerbates the small open economy unit root problem. Finally, the model provides arguments against using the exchange rate as a nominal anchor.