Exercise 3 We have seen over the course of the text that the real exchange rate has important distributive effects, which, in turn, make this variable an element of fundamental importance as a political instrument in the hands of the government. Consider the economic model developed in Section 11.1.

a. What is the impact of a real exchange rate appreciation on the welfare of individuals who produce tradable and nontradable goods? Using a graph with the budget constraint for 326 PRINCIPLES OF INTERNATIONAL FINANCE AND OPEN ECONOMY MACROECONOMICS individuals in each sector, illustrate the impact of a real exchange rate appreciation on the welfare of these individuals. Explain the economic logic for your answer.

b. The relative weight given by the government to two types of citizens can depend on political factors, and this weight can change due to lobby influence. Assume that γ is the true share of individuals in the nontradables sector, and that γ $ α

1 2 α. Now assume that

γp # α

1 2 α # γ is the weight attributed to the sector with the government under lobby influence. What is the impact of lobby action on the welfare of individuals?