1. Suppose that there are only two countries, Poundland and Dollarland. The currency used in Poundland is called "pound"

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1 Suppose That There Are Only Two Countries Poundland And Dollarland The Currency Used In Poundland Is Called Pound 1 (50.29 KiB) Viewed 22 times

1. Suppose that there are only two countries, Poundland and Dollarland. The currency used in Poundland is called "pound" (denoted by E), and the currency used in Dollarland dollar (denoted by $). The two countries produce two goods: a traded good – mobile phones, denoted by subscript t, and a non-traded good — haircuts, denoted by subscript N. The two countries trade freely with each other. There are no transaction costs for trading mobile phones whereas the transaction costs for trading haircuts are prohibitively high. The price level in Poundland, pe is given by pf = (PPS)0.5, and the price level in Dollarland, ps, is given by PS = (PP:) 0.5, where P (PS) is the pound (dollar) price of mobile phones, Pg (Pis the pound (dollar) price of haircuts. The real exchange rate is defined as q = EPF/PS, where E is the nominal exchange rate and defined as the price of the dollar in terms of the pound. The production functions in these two countries are as follows: vf = 0.42 yf = 0.526 yo = 0.81 vi = 0.52 where y denotes output, L denotes the hours of labour input, the subscript T(N) indicates that the variable is associated with the traded (non-traded) good, and the superscript £ ($) indicates that the variable is associated with Poundland (Dollarland). Product and labour markets are perfectly competitive in both countries. Labour can move freely within, but not across, national borders. It is known that the unit price of mobile phones is £40 in Poundland and $20 in Dollarland. (a) What must be the value of the nominal exchange rate between the pound and the dollar? [20 marks] (b) What is the price of haircuts in each country? [30 marks] (c) Calculate the value of the real exchange rate, q. What will happen to the real exchange rate if labour productivity in mobile phone production doubles in Poundland (i.e. the production function becomes Y = 0.8L) while everything else stays the same? [50 marks]