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

IMF Working Papers, June 3, 2022

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

Authors: Marcin Kolasa, Sahil Ravgotra, Pawel Zabczyk
Date: June 3, 2022
Core contribution: An extension of the open economy New Keynesian model in which agents are boundedly rational à la Gabaix (2020), which nests rational expectations (RE) as a special case.
Central mechanism: An uncovered interest rate parity (UIP) condition featuring behavioral expectations rather than RE-driven expectations.

The behavioral model can mitigate many “puzzling” aspects of the relationship between exchange rates and interest rates.
Several UIP puzzles disappear when actual exchange rate expectations are used (instead of realizations implicitly coupled with the RE assumption).
Cognitive discounting:
- Dampens the effects of current monetary shocks.
- Lowers the efficacy of forward guidance (FG).
- Its relative importance in mitigating the FG puzzle is decreasing in openness.
Accounting for myopia:
- Exacerbates the small open economy unit-root problem.
- Makes positive monetary spillovers more likely.
- Increases the persistence of net foreign assets and the real exchange rate.

The setup:
- Extends the open economy New Keynesian framework.
- Incorporates bounded rationality following Gabaix (2020).
- Nests RE as a special case, allowing comparison between behavioral and RE outcomes.
Implications for empirical work:
- Empirical evidence that employs actual exchange rate expectations aligns with model predictions and resolves several UIP anomalies tied to RE-based analyses.
Open economy considerations:
- The mitigating effect of cognitive discounting on the FG puzzle declines with greater openness.
- Behavioral features alter external dynamics—raising persistence and the likelihood of cross-border monetary spillovers.

Subject: Exchange rates, External position, Financial services, Foreign assets, Foreign exchange, Interest rate parity, Real exchange rates, Real interest rates
Keywords: Bounded Rationality, exchange rate dynamics, exchange rate expectation, Exchange Rates, Foreign assets, Interest rate parity, Monetary Policy, monetary policy spillover, monetary policy transmission, RE assumption, Real exchange rates, Real interest rates