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

By Marcin Kolasa, Sahil Ravgotra, Pawel Zabczyk

June 3, 2022

Preview Citation

Format: Chicago

Marcin Kolasa, Sahil Ravgotra, and Pawel Zabczyk. Monetary Policy and Exchange Rate Dynamics in a Behavioral Open Economy Model, (USA: International Monetary Fund, 2022) accessed November 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We develop an extension of the open economy New Keynesian model in which agents are boundedly rational à la Gabaix (2020). Our setup nests rational expectations (RE) as a special case and it can successfully mitigate many “puzzling” aspects of the relationship between exchange rates and interest rates. Since the model implies an uncovered interest rate parity (UIP) condition featuring behavioral expectations, our results are also consistent with recent empirical evidence showing that several UIP puzzles vanish when actual exchange rate expectations are used (instead of realizations implicitly coupled with the RE assumption). We find that cognitive discounting dampens the effects of current monetary shocks and lowers the efficacy of forward guidance (FG), but its relative importance in mitigating the so-called FG puzzle is decreasing in openness. Finally, we show that accounting for myopia exacerbates the small open economy unit-root problem, makes positive monetary spillovers more likely, and increases the persistence of net foreign assets and the real exchange rate.

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

Publication Details

Pages:

44
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2022/112
Stock No:

WPIEA2022112
ISBN:

9798400211935
ISSN:

1018-5941

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