Monetary Policy in a Two-Country Model with Behavioral Expectations

Abstract

We study the working of monetary policy in an estimated two-country model with behavioral expectations (BE). We first show that the data favors this setting compared with the standard rational expectations assumption. Then we document several novel findings related to monetary policy in the open-economy framework. First, under BE the Taylor principle depends on the size of the economy - determinacy regions are larger for the small country. Second, both in the small and large economies, monetary policy is less powerful when agents are behavioral. Third, the sacrifice ratio faced by the central bank increases with agents becoming more behavioral. Fourth, BE help to partly solve the puzzles of excess foreign currency returns (UIP puzzle) and of international monetary independence.

Keywords: behavioral agents, monetary policy, open-economy model