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Problem 2: Real Exchange Rate and Terms of Trade Consider two countries, each producing its own good, with the respective price levels: P= P!-P/ and p*= l-P H, each in the local currency (* indicated foreign market and foreign currency). E is the nominal exchange rate. Further, consider the following price setting by home firms at home and abroad: Pu= MC1-apa, PH = (MC/E)l-a p*a and similarly by foreign firms: P = MC*l-a p*a, Pp = (MC*E)-apa where MC and MC* are the marginal costs of home and foreign firms respectively. 3. Show that this model results in the LOP deviations when a > 0, namely that: PH/Ph = PFE/Pe = Q, where Q denotes the RER. What is the reason for LOP deviations? Problem 2: Real Exchange Rate and Terms of Trade Consider two countries, each producing its own good, with the respective price levels: P= P!-P/ and p*= l-P H, each in the local currency (* indicated foreign market and foreign currency). E is the nominal exchange rate. Further, consider the following price setting by home firms at home and abroad: Pu= MC1-apa, PH = (MC/E)l-a p*a and similarly by foreign firms: P = MC*l-a p*a, Pp = (MC*E)-apa where MC and MC* are the marginal costs of home and foreign firms respectively. 3. Show that this model results in the LOP deviations when a > 0, namely that: PH/Ph = PFE/Pe = Q, where Q denotes the RER. What is the reason for LOP deviations

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