Generalize the two-country model of a floating exchange rate to take account of the distinction between traded and nontraded goods. Assume that the price index in each country is:

where PT, PN are the prices of the two goods in the domestic country, and stars denote the foreign country as usual. PPP applies only to traded goods, since nontraded goods prices are determined in the domestic economy.

﴾a﴿ Derive the equation for the exchange rate in terms of relative money stocks, income and nontraded goods prices.

﴾b﴿ By log differentiation, explain the effect of changes in the exogenous variables and also the part played by the index weights .

Transcribed Image Text:

II = P#P¯a II' = P$* P }¯a• pa*pl-a* a, 1- a