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  5. Monetary Policy in Boundedly Rational Economies
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Monetary Policy in Boundedly Rational Economies

Paper Session

Sunday, Jan. 7, 2024 8:00 AM - 10:00 AM (CST)

Convention Center, 301B
Hosted By: American Economic Association
  • Chair: Yinxi Xie, Bank of Canada

Anchoring Boundedly Rational Expectations

Stephane Dupraz
,
Bank of France
Magali Marx
,
Bank of France

Abstract

How can a central bank avoid losing control over inflation expectations? Under rational expectations, respecting the Taylor principle---increasing rates more than one for one with inflation---prevents self-fulfilling inflation and defines an active monetary policy. We reconsider the issue away from rational expectations, for a large class of boundedly rational expectations featuring both limited foresight and long-term learning. We show three results. (1) When restricting monetary policy to a Taylor rule, the Taylor principle does not prevent self-fulfilling inflation but hyperinflation spirals, unless for unrealistically high degrees of foresight. (2) Against hyperinflation spirals, active monetary policy can be characterized without restricting policy to a Taylor rule, as a sufficient increase of a weighted average of present and future expected policy rates. The weights on future policy rates first increase but then decrease with the horizon, implying that delaying hikes too much requires larger hikes later, with a larger drop in output. (3) Yet, being slow in hiking rates can be optimal provided a large cost on output stabilization, as it spreads the output cost over time.

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

Seunghoon Na
,
Purdue University
Yinxi Xie
,
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. Limited foresight leads to dynamic overshooting of forecast errors in the real exchange rate across different time horizons, while also differentiating the term structure of expectations. This framework hence provides a micro-foundation for understanding time and forecast horizon variability in uncovered interest parity (UIP) puzzles.

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

Marcin Kolasa
,
International Monetary Fund
Sahil Ravgotra
,
University of Surrey
Pawel Zabczyk
,
International Monetary Fund

Abstract

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.

Discussant(s)
Yeji Sung
,
Federal Reserve Bank of San Francisco
Rosen Valchev
,
Boston College
Francesco Bianchi
,
Johns Hopkins University
JEL Classifications
  • E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit
  • F3 - International Finance