Real exchange rate targeting and macroeconomic instability

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.