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

Marcin Kolasa, Sahil Ravgotra and Pawel Zabczyk

Journal of International Economics, 2025, vol. 155, issue C

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.

Keywords: Monetary policy; Exchange rates; UIP condition; Bounded rationality (search for similar items in EconPapers)
JEL-codes: E52 E58 E70 F41 G40 (search for similar items in EconPapers)
Date: 2025
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Related works:
Working Paper: Monetary Policy and Exchange Rate Dynamics in a Behavioral Open Economy Model (2022)
Working Paper: Monetary Policy and Exchange Rate Dynamics in a Behavioural Open Economy Model (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:155:y:2025:i:c:s0022199625000431

DOI: 10.1016/j.jinteco.2025.104087

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