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

This paper investigates exchange rate dynamics in open economies by incorporating bounded rationality. We develop a small open-economy New Keynesian model with an incomplete asset market, wherein decision-makers possess limited foresight and can plan for only a finite distance into the future. The equilibrium dynamics depend on the degree of foresight and the decision-makers’ belief-updating behaviors that approximate continuation values at the end of their planning horizons. This limited foresight leads to persistent, non-monotonic forecast errors in the real exchange rate across time horizons and distinguishes between short- and long-term expectations. This framework hence provides a micro-foundation for understanding time-horizon variability in uncovered interest parity puzzles.