1NOTES ON ACCOUNTING FOR U.S. REAL EXCHANGE RATE CHANGES TP1PT HAKAN YILMAZKUDAY Engel (1999) defines the real exchange rate as a measure of one country’s overall price level relative to another country’s overall price. In order to show the derivation of an expression for real exchange rate, consider the following price index for the home country: ()NtTttpppαα+−=1(1)Here, tpis the log of the price index, Ttpis the log of the traded-goods price index, Ntpis the log of the nontraded-goods price index, and αis the share that nontraded goods take in the price index. Thus, the price index for the home country is a geometric weighted average of traded- and nontraded-goods prices. Analogously, we can also write the price index of the foreign country, as follows: ()***1NtTttpppββ+−=(2)where βis the share of nontraded goods in the foreign price index. By using Equations (1) and (2), we can define the real exchange rate as follows: TP1PTThis paper draws on Engel (1999).
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