Abstract
We analyze different behavioral models of expectation formation in a multi-country New Keynesian currency union model. Our analyses yield the following robust results. First, economic integration is of crucial importance for the stability of the economic dynamics in a currency union. Second, when the economic dynamics are unstable, more activist monetary policy does not lead to stable economic dynamics. These findings have natural counterparts in the rational expectations version of the model: there, economic integration is crucial for the determinacy of the equilibrium and when the equilibrium is indeterminate, more activist monetary policy does not lead to a determinate equilibrium. In an application to euro area data, we find that the behavioral macroeconomic model outperforms its rational counterpart in terms of prediction performance.
Highlights
The economics of currency unions is of great importance
We first show the results on economic integration under the behavioral models of expectation formation and how these compare to the results under rational expectations
We mainly resort to three symmetrical countries to have a simple illustration while still showing that our model is a multi-country model and not a two-country model
Summary
The economics of currency unions is of great importance. Compared with the vast amount of economic research conducted on closed economies, research on currency unions is still relatively sparse. Very few studies analyze currency unions from the perspective of behavioral economics, deviating from full rationality. R We thank an associate editor, two referees, Mariarosaria Comunale, Anh Dinh Minh Nguyen, Cars Hommes, Simas Kucinskas, Kostas Mavromatis, Lucas Radke, Timo Reinelt, and Jonas Striaukas for comments and suggestions, participants of the 2nd Behavioral Macroeconomics Workshop in Bamberg, the ZEW Public Finance Conference in Mannheim, the BEAM-ABEE Workshop in Amsterdam, the Inaugural Baltic Economic Conference in Vilnius, the Baltic Central Bank Meeting in Vilnius, the WEAI meetings in San Diego, and seminar participants at GATE Lyon, Vilnius University, Stockholm School of Economics in Riga, the Bank of Lithuania, and ISM University Vilnius. Part of this research was conducted while Bertasiute and Weber were at the Bank of Lithuania
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