The Federal Reserve Board eagle logo links to Board's home page

International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page PPP Rules, Macroeconomic (In)stability and Learning
Luis-Felipe Zanna
2004-814  (September 2004)

Abstract:  Governments in emerging economies have pursued real exchange rate targeting through Purchasing Power Parity (PPP) rules that link the nominal depreciation rate to either the deviation of the real exchange rate from its long run level or to the difference between the domestic and the foreign CPI-inflation rates. In this paper we disentangle the conditions under which these rules may lead to endogenous fluctuations due to self-fulfilling expectations in a small open economy that faces nominal rigidities. We find that besides the specification of the rule, structural parameters such as the share of traded goods (that measures the degree of openness of the economy) and the degrees of imperfect competition and price stickiness in the non-traded sector play a crucial role in the determinacy of equilibrium. To evaluate the relevance of the real (in)determinacy results we pursue a learnability (E-stability) analysis for the aforementioned PPP rules. We show that for rules that guarantee a unique equilibrium, the fundamental solution that represents this equilibrium is learnable in the E-stability sense. Similarly we show that for PPP rules that open the possibility of sunspot equilibria, a common factor representation that describes these equilibria is also E-stable. In this sense sunspot equilibria and therefore aggregate instability are more likely to occur due to PPP rules than previously recognized.

Full paper (471 KB PDF) | Full paper (screen reader version)

Small open economy, multiple equilibria, sunspot equilibria, indeterminacy, expectational stability and learning

PDF files: Adobe Acrobat Reader   ZIP files: PKWARE

Home | IFDPs | List of 2004 IFDPs
Accessibility | Contact Us
Last update: October 24, 2006