Exercise 7 Consider a world where there are two countries, denominated A and B, which have trade relations, in an economic environment identical to that presented in Section 5.3. In each country, tradable goods are classified as either exported or imported. The production structures for both countries are identical, differing only in their parameters, which are presented by the superscript i, iAfA; Bg. As such, Ki represents variable K in country i. The structure of household preferences is identical in both countries, differing only in the parameters that are also identified by the superscript i, iAfA; Bg.

a. Solve the producer optimization problem in country i, obtaining the supply of the exported good, the imported good, and the nontradable good.

b. Find the price of the nontradable good, assuming that the production function parameters do not alter over time. Obtain the real exchange rate.

142 PRINCIPLES OF INTERNATIONAL FINANCE AND OPEN ECONOMY MACROECONOMICS

c. For country A to be a net exporter of good X it is necessary that condition aA X

aA M

. aB X

aB M

is valid. Present an economic interpretation for this condition.

d. Assume that aA X

aA M

. aB X

aB M

is valid, what happens when there is an increase in the terms of trade? Analytically justify your answer and present an economic intuition for the result.