32 Pages Posted: 7 Sep 2000
Date Written: October 23, 2002
Using an optimizing model of a small open economy, this paper studies the macroeconomic effects of PPP rules whereby the government increases the devaluation rate when the real exchange rate - defined as the price of tradables in terms of nontradables - is below its long-run level and reduces the devaluation rate when the real exchange rate is above its long-run level. The paper shows that the mere existence of such a rule can generate aggregate fluctuations due to self-fulfilling revisions in expectations. The result is shown to obtain in both flexible- and sticky-price environments.
Keywords: real exchange rate targeting, sunspot equilibria, indeterminacy
JEL Classification: F41
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