A general equilibrium model with real exchange rates

Abstract

Abstract In this paper, I revisit the Balassa-Samuelson effect. I explain that the behaviour of the real exchange rate shows structural breaks only in the short term. I also explain that any change in a currency’s price in terms of another currency in real terms is transitory in the very long run, thereby disappearing after a certain period of time. I first write a partial equilibrium model “á la Rogoff” where there are relative prices of non-tradable goods in terms of tradables goods in the supply side. Secondly, I obtain a general equilibrium model after I add a utility function to the partial-equilibrium model. In the general equilibrium model, I find that any price's change in non-tradables goods will be compensated by either way a price´s change in tradables goods or changes in the nominal exchange rate. The mathematical mechanism behind the general equilibrium model shows a stationary state in the real exchange rate considering not only non-tradables goods but also tradables goods either in the domestic market and the foreign market. Therefore, the real exchange rate is constant over the time in the long run. JEL Classification F31, F41