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

Michal Brzoza-Brzezina, Paweł Galiński and Makarski Krzysztof

No 2025-110, KAE Working Papers from Warsaw School of Economics, Collegium of Economic Analysis

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).

Keywords: behavioral agents; monetary and fiscal policy; open-economy model (search for similar items in EconPapers)
JEL-codes: E30 E43 E52 E70 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2025-03
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mon
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Journal Article: Monetary and fiscal policy in a two-country model with behavioral expectations (2025)
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Persistent link: https://EconPapers.repec.org/RePEc:sgh:kaewps:2025110

DOI: 10.33119/kaewps2025110

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