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

Structural analyses of exchange rate dynamics and monetary policy have often been built upon the rational expectations (RE) assumption that decision-makers can correctly deduce future economic outcomes infinitely far. In this paper, we instead relax the RE assumption in a standard small open-economy New Keynesian model with an incomplete asset market in which agents are subject to limited foresight -- they can only plan for a finite distance into the future in decision-making. The equilibrium dynamics of the model relies on both the degree of decision-makers' foresight and how fast they update their belief that is used to approximate continuation values at the end of their planning horizons. Our model further provides a unified framework that can explain key features of the uncovered interest rate parity (UIP) puzzles: (i) predictability reversal of the excess return across the horizon and (ii) the short-run overreaction and the long-run underreaction of the real exchange rate to expected real interest rate differentials