Misspecified Expectations in an Open Economy

Abstract

In the past two decades, Turkey has experienced multiple changes in its monetary policy regime.To analyse how these policy changes affect the behaviours of households and firms, somebehavioural parameters are incorporated into a small open economy New Keynesian model. Ourapproach consists of four phases. First, we assess the impacts of the behavioural parameters onthe model and find that higher values of the parameters increase the effects of expectationson the model. Second, for the period between 2006 and 2021, the model is estimated for theTurkish economy and the findings show that both households and firms are more forward-looking in their decision making. Moreover, the current variables have a weak effect on thenominal interest rate, and the inertial nominal interest rate has a strong effect on it. Third, weanalyse the evolution of the model parameters over the period and find that the behaviouralparameters tend to increase, while the monetary policy becomes more inertial. Finally, weconclude that the Central Bank should follow Domestic Inflation-based Taylor rule to minimise welfare loss