Exercise 3 Consider the same model as in the previous exercise, with domestic and foreign price indexes given by P 5 Pα

NP12α T and P 5 Pβ

N P12β

T , respectively, and with α; βAð0; 1Þ. Now assume that consumers in the domestic economy spend fraction γ of their total expenditures on domestically produced, tradable goods, represented by H, and a share, 1 2 γ, on tradable goods produced abroad, which are represented by F. In the foreign economy, there is an analogous behavior, with a fraction of spending on tradable goods produced in the domestic economy, designated as γ Using a Cobb
Douglas type function, the price index for tradable goods will be given as PT 5 Pγ

HP12γ

F and P 5 Pγ

H P12γ

F .

a. Define the real exchange rate of tradable goods as RERT  SP

T PT .

b. Based on the Law of One Price, what is the expected relation between the prices of goods H and F?

c. Use the ratios SP

F PF and SP

H PH to identify the real exchange rate determiners for the tradable goods.

d. Qualify the following statements as either true or false and justify your answer.

1. If the Law of One Price is valid, then the real exchange rate will be equal to 1.

2. If the Law of One Price is valid, then the real exchange rate for tradable goods RERT will be equal to 1.