Exercise 2 Consider an economic environment where there are two economies, a domestic and a foreign. Assume that the price levels in the domestic economy are given by P 5 Pα

NP12α T , where PT represents the price of tradables and PN the price of nontradable goods. The price level in the foreign economy is given by P, where P 5 Pβ

N P12β

T . In relation to the price indexes, we have that α; βAð0; 1Þ. The real exchange rate, designated by RER, is defined as RER  SP

P , where S is the nominal exchange rate in terms of the domestic currency necessary to purchase one unit of foreign currency.

a. Show that, if the Law of One Price is valid for tradable goods and if the ratio P

N P

T is approximately constant, then changes in the real exchange rate are for the most part explained by changes in the ratio PN PT

. If the foreign economy is significantly developed, do you think it is reasonable to consider the hypothesis that P

N P

T is approximately constant?

Explain your answer.

Chapter 5 • The Equilibrium Real Exchange Rate 139

b. Present a brief summary of the Balassa
Samuelson model, listing the main hypotheses used.

c. Explain how changes in the terms of trade affect the equilibrium real exchange rate.

d. Throughout the 2000s, the real exchange rate in the Brazilian economy appreciated significantly in relation to the American dollar. Using your answers to the previous items, explain the movement of the Brazilian real exchange rate. Will this appreciation be permanent?

e. In which of the following situations would you expect the Brazilian real exchange rate to present the greatest appreciation: When measured based on the Consumer Price Index or when measured by the Producer Price Index?