Discussion Paper No. 110 of 2010 on General Equilibrium Real Exchange Rates in Three-Good Economy Setting

Abstract

This study develops a theoretical general equilibrium model of the determination of the equilibrium long-run real exchange rates in a three-good open economy framework. Three economic agents are considered in the model: a representative consumer, a representative firm, and the government sector. Two goods are produced by the representative firm: a non-tradable good, and an exportable good while the consumer demands two goods: the non-tradable good, and an imported good. The three agents interact in an internal-external equilibrium framework. Comparative statistics from the developed equilibrium long-run real exchange rate show that the long-run real exchange rate depreciates as government spending on the traded goods increases, and it appreciates as foreign interest rates increase. On the other hand, an increase in the world interest rates appreciates the real exchange rates, while an increase in capital outflow depreciates the real exchange rates. In general, this study adds to the existing knowledge of the determination of the long-run real exchange rates by suggesting that the real sector variables, including the capital labour ratio, are important determinants of the long-run real exchange rates.