solution_ps3

solution_ps3 - Econ315: International Macroeconomics...

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Econ315: International Macroeconomics Solution problem set 3 Note: this problem set will be graded. In the second part of the course problem sets will be graded every other time . 1) a)As in the lecture notes (Lecture 4), the real exchange rate is de¯ned as RER = eP ¤ P We assume that the domestic price level P is given by P = ( P N ) a ( P T ) 1 ¡ a and that the foreign price level P ¤ is given by P ¤ = ( P ¤ N ) b ( P ¤ T ) 1 ¡ b where P N ( P ¤ N ) is the domestic (foreign) price index for non trade goods, P T ( P ¤ T ) is the domestic (foreign) price index for trade goods and 0 < a;b < 1. We can write RER = eP ¤ P = eP ¤ T P T £ ( P ¤ N =P ¤ T ) b ( P N =P T ) a If the law of one price holds for traded goods then eP ¤ T P T = 1. From inspection it follows that if ( P ¤ N =P ¤ T ) is approximately constant then variations in the real exchange rate can be explained in terms of variations in the ratio P N =P T : If the foreign country is a developed country, it is likely to experience slower technological change than some developing countries. If this is the case then the relative price between its tradeable and non-tradeable goods will be fairly stable compared to the developing country. b) The presence of non-traded goods suggests that international variations in the prices of non-tradeable could be a source of international di®erences in price levels between rich and poor country. We will assume that there are tow countries and they produce two goods: a tradeable (T) and non-tradeable (NT). The key assumptions are that:
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solution_ps3 - Econ315: International Macroeconomics...

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