If the households share the behavioral bias of firms, exchange rate volatility is amplified, and the contractionary effect of depreciation becomes quantitatively important. The full paper is available at 11/11.

Behavioral expectations of firms make the contractionary aggregate demand channel stronger relative to the expansionary expenditure-switching channel. They can potentially reverse the sign of output response and lead to a contractionary depreciation. 10/11.

The second channel is more sensitive to the expectations. The forward-looking price-setting of firms prompts monetary authorities to raise the trajectory of domestic interest rates. Rational households predict the path of prices and interest rates and reduce consumption. 9/11.

There are two opposing effects of depreciation on output. First, the tradable sector expands as depreciation makes it more competitive. Second, the aggregate demand falls due to increased borrowing costs and prices, resulting in a contraction in the non-tradable sector. 8/11.

Behavioral firms misspecify the financial shock process, and I use Fact 1 to discipline their bias. The firms believe both shock and the exchange rate to be overly persistent. Next, I show that this bias affects the response of output to depreciation. 7/11.

The exchange rate is driven by financial shock to the uncovered interest parity condition, which raises the effective interest rate on dollar assets and depreciates the local currency. Among domestic shocks, only financial shock generates expectations consistent with Fact 2. 6/11.

To examine the aggregate impact of exchange rate expectations, I integrate behavioral beliefs into a small open economy model with tradable and non-tradable sectors. To set sticky prices, firms must forecast future demand and costs, which are affected by the exchange rate. 5/11.

Fact 2: Firms associate depreciations with a contractionary economic environment. Firms that expect depreciation are more likely to expect low output growth and high inflation. They report having contracted their economic activity and plan to contract it in the near future. 4/11.

Fact 1: Exchange rate forecasts are not rational, and the errors can be predicted using information available at the time of the forecast. Firms tend to overreact to news and anchor their expectations to the observable value of the exchange rate. 3/11.

To study expectation formation, I analyze firm-level survey data on exchange rate forecasts collected by the Central Bank of Peru. I document two stylized facts: 2/11.

Hi #EconTwitter! I'm excited to share my JMP, where I address two questions: First, how do economic agents form their exchange rate expectations? Second, how do these expectations affect the transmission of aggregate shocks? 1/11