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A Behavioral New Keynesian Model of a Small Open Economy Under Limited Foresight

Seunghoon Na and Yinxi Xie

Staff Working Papers from Bank of Canada

Abstract: This paper investigates exchange rate dynamics in open economies by incorporating bounded rationality. We develop a small open-economy New Keynesian model with an incomplete asset market, wherein decision-makers possess limited foresight and can plan for only a finite distance into the future. The equilibrium dynamics depend on the degree of foresight and the decision-makers’ belief-updating behaviors that approximate continuation values at the end of their planning horizons. This limited foresight leads to persistent, non-monotonic forecast errors in the real exchange rate across time horizons and distinguishes between short- and long-term expectations. This framework hence provides a micro-foundation for understanding time-horizon variability in uncovered interest parity puzzles.

Keywords: Exchange rates; Monetary policy transmission; International topics; Business fluctuations and cycles (search for similar items in EconPapers)
JEL-codes: E43 E70 F31 F41 (search for similar items in EconPapers)
Pages: 70 pages
Date: 2023-08
New Economics Papers: this item is included in nep-cba, nep-dge and nep-opm
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Handle: RePEc:bca:bocawp:23-44