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

Marcin Kolasa, Sahil Ravgotra and Pawel Zabczyk

No 2025-111, KAE Working Papers from Warsaw School of Economics, Collegium of Economic Analysis

Abstract: We analyze the implications of adding boundedly rational agents a 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. On the normative side, the model with behavioral agents provides arguments against using the exchange rate as a nominal anchor.

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)
Pages: 52 pages
Date: 2025-03
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mon
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https://hdl.handle.net/20.500.12182/1333 (application/pdf)

Related works:
Journal Article: Monetary policy and exchange rate dynamics in a behavioral open economy model (2025)
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:sgh:kaewps:2025111

DOI: 10.33119/kaewps2025111

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