Openness, relative prices, and macro-policies

This paper analyzes the role of relative prices in the conduct of wage indexation, monetary policy, and exchange rate policy in a small economy producing traded and nontraded goods under a managed float exchange rate regime. It is shown that the beneficial effect of using relative prices in addition to aggregate prices as indicators for the conduct of the above policies increases with openness. The response of policies to relative prices rises with openness, and has dampening effects on the volatility of deviations from purchasing power parity.