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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 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. We also show that accounting for agents' myopia makes positive international monetary spillovers more likely, increases the persistence of the real exchange rate and net foreign assets, and exacerbates the small open economy unit root problem. Finally, the model provides arguments against using the exchange rate as a nominal anchor.
Presented at: MMF PhD Conference, Edinburgh (April 2022); CEF, Dallas (June 2022); 4th Behavioral Macroeconomic workshop, Bamberg (June 2022); Dynare Conference, Lancaster University (June 2022); EEA Congress, Milan (Aug 2022); MMF Conference, Canterbury (Sept 2022)