The real exchange rate plays a crucial role in models of the open economy. How should the real exchange rate be defined, how does it behave over time, and what determines it at various time horizons are all questions that have been posed over the years. They have taken on heightened importance in recent years, as the scope of international transactions has expanded and more and more economic activity is either directly or indirectly affected by economic activity in other countries. The most common definition of the real rate is the nominal exchange rate adjusted by price levels. q t ≡ st- p + p t t (1) where s is the log exchange rate defined in units of home currency per unit of foreign, and p and p * are log price levels. If purchasing power parity (PPP) holds, then q is always unity (or a constant, if price indices are used). One should expect PPP to hold in a world where transportation and transactions costs were negligible, consumption baskets were identical, and no arbitrage profits existed. Absent these conditions, the real exchange rate will vary. One way of thinking about the determinants of movements in the real exchange rate is to appeal to a decomposition. Suppose the price index is a geometric average of traded and nontraded good prices. p = α p t
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