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Ch22-SM - S207-S212-Ch22-SM2.qxd 11:53 AM Page S-207 Topics...

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Topics in International Macroeconomics 1. (PPP) Richland and Poorland each have two industries,traded TVs and nontraded house maintenance.The world price of TVs is RL$100 (RL$ Richland dollar).Assume for now that the exchange rate is R$1 1 PL peso (PL Poorland peso) and that prices are flexible. It takes 1 day for a worker in each country to visit and maintain 1 house. It takes 1 day for a Richland worker to make a TV, and 4 days for a Poorland worker. In the following analysis, Richland is treated as the Home country and Poorland as the Foreign country. a. What is the Richland wage in RL$ per day? What is the Poorland wage in PL per day? In R$ per day? What is the ratio of Poor to Rich wages in a common currency? Answer: Richland wage per day: w A R $100. Poorland wage per day: A * 25 PP , or Ew * R $25. The ratio of Poorland’s wage to Richland’s is equal to 1/4 ( R$25 / R$100). b. What is the price of a house maintenance visit in each country? Answer: Price of nontraded housing services in Richland: p N A R $100. Price of nontraded housing services in Poorland: Ep * N A * 25 PP R $25. c. Assume people in each country spend half their income on TVs and half on house maintenance. Calculate the CPI (consumer price index) for each country given by the square root of (TV price) times (gardening price). Answer: CPI in Richland: R $100 R $100 R $100. CPI in Poorland: 25 PP 25 PP 25 PP . d. Calculate the standard of living in each country by dividing local currency wages by the CPI from (c). Is Poorland really as poor as suggested by the last answer in (a)? Answer: Standard of living in Richland: 1 . Standard of living in Poorland: 1 . No, Poorland and Richland have the same living standards.Although wages are lower in Poorland,the cost of goods is lower.Real wages are the same in the two countries. 25 PP 25 PP R $100 R $100 S-207 22
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e. Productivity now doubles in the Poorland TV industry, all else equal. How many days does it now take for Poorland workers to make a TV? What happens to the wage in Poorland? The price of housing services? The CPI? Answer: If productivity doubles, then workers in Poorland can now make one television in two days (instead of four). Productivity rises from 25PP per day to 50PP per day. Price of nontraded housing services in Poorland: Ep * N A * 50 PP R $50. We can calculate the change in the CPI using the expression given in the text- book: (1 n ) n n 0.5(1) 0.5 Therefore, the CPI in Poorland rises by 50% (to 37.5).Alternatively, we can cal- culate the new CPI directly, using the method given in the question: New CPI in Poorland: 25 PP 50 PP 35.4 PP . The two values are not identical, but they imply a similar increase—an inflation rate equal to roughly 50%. f. If the central bank of Poorland wants to avoid inflation in this situation, how would it like to adjust the exchange rate? Answer: To avoid inflation,the nominal exchange rate will need to adjust to ab- sorb the implied change in the real exchange rate: If the central bank does nothing, then the adjustment will work through relative prices: 0.5 ( 0.5) We can see from the previous expression that to avoid the 50% inflation rate, the
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