ONLY NEED PART B QUESTION!

A Model of the Real Exchange Rate in the Long Run

?The determinants of thereal exchange ratework through factors that account for deviations fromPPP; that is, the factors that tend to hinder trade:

oTransportation costs.

oImperfect competition.

oDifferences in institutions, government regulations, and taxes.

Macroeconomics Background Note 64

• ?To examine the consequence of these factors for the real exchange rate, first note that the cost of production of goods in each country can be broken down into easilytradablecomponents andnon- tradablecomponents.
• oFor example, the wheat used in a Big Mac is easily tradable, but the cooking services are not. Another example is shirts: the shirts themselves are tradable, but the marketing, distribution, and sales efforts typically require non-tradable local labor, transportation, shop floor, insurance, etc..

. If Pr is the price index for the tradable components of all goods sold in Home country and PN is the price index for the non-tradable components of those goods and if we use * to denote the price levels in the Foreign country, we have P = BPN+ (1 -B)Pr in the Home country, P* = B"PN* + (1 -B') PI* in the Foreign country, where B and B" are the shares of non-tradables in the total cost of goods in the two countries. . Then, E can be written as: EP E= p * = E[BPN + (1 -B)Pr] EPT B(PN / PT ) + (1-B) B"PN + (1-B" ) PT B"( PN / PT ) + ( 1-B* ) . Factoring out Pr in the numerator and Pr in the denominator, we find: E = EPT B(PN / PT ) + (1-B) PT LB" ( PN / PT) + ( 1-B")] . For the tradable components, the PPP holds and we can assume that ePr = Pr in the long run. Therefore, the last above equation simplifies to: (6.1) (= B(PN / PT ) + (1-B) B* ( PN /PT ) + (1-B* )