The Behavioral Economics of Currency Unions: Economic Integration and Monetary Policy

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.