Macro-economic Stability and Policy Rules in a Two-Sector Model of an Open Economy.

Purchasing power parity exchange-rate rules are often used in open economies to stabilize the demand for exports and domestic output. R. Dornbusch (1982) shows tha t such rules may increase the variability of output via the supply si de by destabilizing the price of imported intermediate goods. Here a two-sector, wage-spillover model is employed to demonstrate that this result is more likely because although exchange-rate indexation woul d decrease the variability of output in the traded goods sector, it m ay increase the variability of output in the nontraded goods sector a nd in the aggregate via the wage linkage between sectors.