Monetary Policy in Open Economies with Behavioral Expectations and Inflation Contagion

This dissertation presents a novel NKM (New Keynesian Model) framework for large open economies incorporating heterogeneous expectations and direct inflation contagion. A key innovation is the introduction of a transmission channel between economies based on behavioral expectation formations, a concept previously unexplored in the literature. Analyzing conventional and unconventional monetary policy responses, the work demonstrates that this new expectation channel significantly influences optimal monetary policy decisions. Specifically, the decision of whether a central bank should react to foreign exchange (FX) rate movements hinges on the strength of the newly introduced expectation channel. However, central banks should incorporate foreign country developments into their strategies, particularly when the expectation channel is strong. Additionally, this dissertation finds that a stylized intervention in the FX market can stabilize the economy and reduce welfare loss if the central bank loses credibility. Furthermore, FX market intervention can also mitigate the disruptive effects of negative demand shocks, particularly when interest rates are constrained by an effective lower bound. Further, this work shows that monetary policy coordination becomes more effective in the presence of the expectation channel. Lastly, this dissertation additionally extends its analysis to a TANK model for a large open economy, providing valuable insights for monetary policy decisions.

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