Macroeconomics, 2nd Edition by Pearson

146

MACROECONOMICS

transactions costs, the domestic price should be the foreign price times the

exchange rate, or

P

i

=

EP

i

*

(5.13)

If

P

i



EP

i

*

, then an arbitrageur would have an incentive to buy the good

abroad where it is cheap and ship it into the domestic market where it is dear.

In the process, the arbitrageur will push up the price abroad and push down

the domestic price until prices are equal in the two locations. If we assume

that the domestic price index

P

=

f

(

P

1

…,

P

i

,

…

,

P

n

) and the foreign-price index

P

*

=

g

(

P

1

*

…

,

P

i

*

,

…

,

P

n

*

) are made up of the same ...