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

Michal Brzoza-Brzezina, Paweł R. Galiński and Krzysztof Makarski

Journal of International Money and Finance, 2025, vol. 155, issue C

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 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. In contrast, the spillovers of monetary policy are dampened. Fourth, behavioral expectations contribute to solving the puzzle of excess foreign currency returns (UIP puzzle).

Keywords: Behavioral agents; Monetary policy; Open-economy model (search for similar items in EconPapers)
JEL-codes: E30 E43 E52 E70 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:155:y:2025:i:c:s026156062500066x

DOI: 10.1016/j.jimonfin.2025.103331

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