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Real exchange rate targeting and macroeconomic instability

  • Martin Uribe

This paper introduces a real exchange rate rule of the type analyzed by Dornbusch (1982) in an optimizing, two-sector, monetary model of a small open economy. By this rule the government increases the devaluation rate when the real exchange rate is below its long-run level and reduces it when the real exchange rate is above its long-run level. I show that the mere existence of such a rule can give room for extrinsic uncertainty to have real effects, that is, it can generate economic fluctuations due to self-fulfilling expectations. I also analyze the stabilizing role of these PPP rules when fluctuations are driven by shocks to fundamentals. I show that the volatility of real variables decreases with tighter rules when shocks to the supply of home goods or to the real rate of return are the main source of uncertainty, and increases when fluctuations are mainly due to shocks to the supply of traded goods. In all cases, PPP rules increase the volatility of nominal variables. Finally, PPP rules help stabilize both real and nominal variables when fluctuations originate from random but persistent deviations from the PPP rule itself.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 505.

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Date of creation: 1995
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Handle: RePEc:fip:fedgif:505
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  1. Tjalling C. Koopmans, 1959. "Stationary Ordinal Utility and Impatience," Cowles Foundation Discussion Papers 81, Cowles Foundation for Research in Economics, Yale University.
  2. Jeffrey A. Frankel & Andrew K. Rose, 1996. "Currency crashes in emerging markets: an empirical treatment," International Finance Discussion Papers 534, Board of Governors of the Federal Reserve System (U.S.).
  3. Carlos A. Végh Gramont & Guillermo Calvo & Carmen Reinhart, 1994. "Targeting the Real Exchange Rate; Theory and Evidence," IMF Working Papers 94/22, International Monetary Fund.
  4. Rebelo, Sérgio, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," CEPR Discussion Papers 1220, C.E.P.R. Discussion Papers.
  5. Michael W. Klein & Nancy P. Marion, 1994. "Explaining the Duration of Exchange-Rate Pegs," NBER Working Papers 4651, National Bureau of Economic Research, Inc.
  6. Graciela L. Kaminsky & Carmen M. Reinhart, 1996. "The twin crises: the causes of banking and balance-of-payments problems," International Finance Discussion Papers 544, Board of Governors of the Federal Reserve System (U.S.).
  7. Reinhart, Carmen & Ostry, Jonathan, 1991. "Private Saving and Terms of Trade Shocks," MPRA Paper 13716, University Library of Munich, Germany.
  8. Reinhart, Carmen M. & Vegh, Carlos A., 1995. "Nominal interest rates, consumption booms, and lack of credibility: A quantitative examination," Journal of Development Economics, Elsevier, vol. 46(2), pages 357-378, April.
  9. Arrau, Patricio & De Gregorio, Jose & Reinhart, Carmen M. & Wickham, Peter, 1995. "The demand for money in developing countries: Assessing the role of financial innovation," Journal of Development Economics, Elsevier, vol. 46(2), pages 317-340, April.
  10. Giovannini, Alberto, 1985. "Saving and the real interest rate in LDCs," Journal of Development Economics, Elsevier, vol. 18(2-3), pages 197-217, August.
  11. Uribe, Martin, 1997. "Hysteresis in a simple model of currency substitution," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 185-202, September.
  12. Rudiger Dornbusch, 1980. "Exchange Rate Rules and Macroeconomic Stability," NBER Working Papers 0473, National Bureau of Economic Research, Inc.
  13. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
  14. Dornbusch, Rudiger, 1982. "PPP Exchange-Rate Rules and Macroeconomic Stability," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 158-65, February.
  15. Mendoza, Enrique G. & Uribe, Martin, 2000. "Devaluation risk and the business-cycle implications of exchange-rate management," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 239-296, December.
  16. Reinhart, Carmen & Vegh, Carlos, 1994. "Intertemporal consumption substitution and inflation stabilization:An empirical investigation," MPRA Paper 13427, University Library of Munich, Germany.
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