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engel - NOTES ON ACCOUNTING FOR U.S REAL EXCHANGE RATE...

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1 NOTES ON ACCOUNTING FOR U.S. REAL EXCHANGE RATE CHANGES T P 1 P T 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: ( ) N t T t t p p p α α + = 1 (1) Here, t p is the log of the price index, T t p is the log of the traded-goods price index, N t p is the log of the nontraded-goods price index, and α is 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: ( ) * * * 1 N t T t t p p p β β + = (2) where β is 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: T P 1 P T This paper draws on Engel (1999).
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