Problem 2: Real Exchange Rate and Terms of Trade Consider two countries, each producing its own good, with the respective price levels: P= P.-^PI and P* = Pil-PHY, each in the local currency (* indicated foreign market and foreign currency). E is the nominal exchange rate. Further, consider the following price setting by home firms at home and abroad: Ph = MC1-a pa, PH = (MC/E)l-a p*a and similarly by foreign firms: P = MC*l-ap*a, Pp = (MC*E)l-a pa, where MC and MC* are the marginal costs of home and foreign firms respectively. 1. Explain the meaning of the equations above and of the parameters y [0,1/2] and a (0,1). Why do we refer to 1-y as the measure of the home bias and to a as the strategic complementarity in price setting? Why firms find it optimal to behave this way? Problem 2: Real Exchange Rate and Terms of Trade Consider two countries, each producing its own good, with the respective price levels: P= P.-^PI and P* = Pil-PHY, each in the local currency (* indicated foreign market and foreign currency). E is the nominal exchange rate. Further, consider the following price setting by home firms at home and abroad: Ph = MC1-a pa, PH = (MC/E)l-a p*a and similarly by foreign firms: P = MC*l-ap*a, Pp = (MC*E)l-a pa, where MC and MC* are the marginal costs of home and foreign firms respectively. 1. Explain the meaning of the equations above and of the parameters y [0,1/2] and a (0,1). Why do we refer to 1-y as the measure of the home bias and to a as the strategic complementarity in price setting? Why firms find it optimal to behave this way