Real Adjustment and Exchange Rate Dynamics.pdf

# 3 this plays an important role in the behavior of the

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3 This plays an important role in the behavior of the model. 9.1.1 The Market for Services The domestic demand for services depends on all prices and on domes- tic real income. 4 (1) c s = - e s Ps + ZBPB + *MPM + ^y The only source of changes in national income which we consider is a discovery of the resource or "specific factor" used in the production of benzine, denoted by v, so we can write real income as (2) y = Q v v, where Q v is the share of the specific factor in national income. 5 Letting e be the nominal exchange rate (i.e., the domestic price of foreign cur- rency), we define the real exchange rate, TT, as (3) ^ = e -p s . By appropriate choice of units we can set the levels of the foreign currency prices of manufactures and benzine equal to unity, so their domestic prices are given simply by the nominal exchange rate (i.e., PB = PM = e )- Noting that the compensated price elasticities in (1) must be related by e B + e M = e s , and using (2) and (3), we can rewrite (1) as (4) c s = e s 7T + r\Q v v. Equation (4) shows that the domestic demand for services is an increasing function of the real exchange rate and of the availability of the natural resource. 3. Note also that output of benzine is a predetermined variable while output of manufac- turing and services can adjust on impact since the allocation of labor can respond instan- taneously. 4. Unless otherwise noted, all variables are in logarithmic form and all coefficients are positive. In principle, the compensated elasticities e B and e M can be positive or negative; we assume in what follows that all commodities are net substitutes, so e B and e M are positive. 5. Changes in the terms of trade can of course also create income effects. Elsewhere (Neary and Purvis 1982) we have analyzed the consequences of such disturbances in the presence of domestic price rigidities.

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289 Real Adjustment As noted earlier, we postulate that the production of services involves only labor, a useful simplification which reflects the relative labor inten- sity of service sectors in most economics. This allows us, by appropriate choice of units, to identify the demand for services with the demand for labor in the services sector, c s = £ s , and the price of services with the wage rate, p s = w. Recalling that p M = e, we can therefore reinterpret the real exchange rate as the inverse of the real wage in the manufacturing sector. (3') TT= ~(w-p M ). Equation (4) thus shows that the demand for labor in services depends negatively on the manufacturing real wage and positively on the stock of the natural resource. 9.1.2 Short-Run Equilibrium in the Market for Labor Labor, it will be recalled, is assumed to be fully employed at all times, with the total stock of labor allocated between the manufacturing and services sectors. The demand for labor in manufacturing, £ M , depends on the (predetermined) capital stock in that sector, k M , and on the manufac- turing real wage rate: where y M is the real wage elasticity of the demand for labor in manufac- turing. Using equation (3') we can rewrite this as (5) M ^k M + ^/ M Tr.

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