Purchasing power parity versus fixed exchange rate rules: a stability and welfare analysis

Abstract

This paper evaluates the desirability of PPP rules vis?á?vis fixed exchange rates both in terms of welfare and stability properties. The analysis is conducted within a small open?economy New Keynesian framework extended to include a cost channel. In terms of stability, we find that while the equilibrium is always unique under fixed exchange rates its uniqueness critically depends upon the presence/absence of the cost channel under a PPP rule. Overall, then, in terms of welfare a fixed exchange rate always outperforms a PPP rule.