1. (PPP) Richland and Poorland each have two industries, traded TVs and nontrade
ID: 1148660 • Letter: 1
Question
1. (PPP) Richland and Poorland each have two industries, traded TVs and nontraded house maintenance. The world price of TVs is RL$100 (RLS = Richland dollar). Assume for now that the exchange rate is R$1 -1 PL peso (PL Poorland peso) and that prices are flexible. It takes 1 day for a worker in each country to visit and maintain 1 house. It takes 1 day for a Richland worker to make a TV, and 4 days for a Poorland worker. In the following analysis, Richland is treated as the Home country and Poorland as the Foreign country.Explanation / Answer
e) Answer: When the productivity doubles, Poorland will be in a position to make one television in two days (instead of four). Productivity increases from 25PP per day to 50PP per day. Thus the price of nontraded housing services in Poorland will be $50.
New CPI = Square root of (100PP*50P) = 70.7P
f) Answer: The inflation rate for Poorland indicates an increase in its CPI of nearly 41.4% (= (70.7-50)/50). Because of an increase in the traded sector productivity of Poorland, the real exchange rate among Richland and Poorland, has risen by 41.4%. To avoid a rise in its price level, i.e., P*, Poorland needs to adjust its exchange rate in a way that P* = 50 as before, EP* = 70.7 as indicated by the present real exchange rate. Hence, to avoid inflation Poorland needs to appreciate its exchange rate from 1R$/PP to 1.41R$/PP