PS5_solutions - DEPARTMENT OF ECONOMICS UNIVERSITY OF...

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DEPARTMENT OF ECONOMICS FALL 2009 UNIVERSITY OF CALIFORNIA, BERKELEY ECON 182 Problem Set 5 Due in class on Thursday, October 8 th at the beginning of lecture . Students that show their work and write neatly will be graded favorably. Please write your full name, GSI, and section time on your problem set. 1. The Real Exchange Rate and Terms of Trade Consider a model in which all goods are traded across borders. Domestic consumers spend a share γ of their spending on home-produced goods and a share 1 – γ on foreign- produced goods. Similarly, Foreign consumers spend a share γ * of their spending on home- produced goods and a share 1 - γ * on foreign-produced goods. The price of goods produced at home is denoted P H and the price of goods produced abroad is denoted by P F . Thus, using a Cobb-Douglas utility function, we can write ܲ ൌ ܲ ܲ ி ଵିఊ ܲ כ ൌ ܲ כ γ* ܲ ி כ 1-γ* where ܲ and ܲ כ are the price indices for these tradable goods at home and abroad. In this model the real exchange rate is defined as ܴܧܴ ؠ ா௉ כ Let’s also define a terms of trade (ToT) variable, which denotes the price of home exports in terms of its imports ܶ݋ܶ ൌ ா௉ כ Economists refer to an increase in the price of home exports relative to home imports as a terms-of-trade improvement. a). What would the law of one price for tradables suggest about the prices of goods at home and abroad? The law of one price implies that if there is perfect arbitrage, a given good must sell at the same
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This note was uploaded on 02/07/2010 for the course ECON 182 taught by Professor Kasa during the Spring '08 term at University of California, Berkeley.

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PS5_solutions - DEPARTMENT OF ECONOMICS UNIVERSITY OF...

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